Residential rental property is usually considered a passive activity from a tax perspective (there are exceptions). This means if the activity generates losses, the losses are passive losses. Passive losses usually can only be used to offset passive income. If you have one rental property that makes a $5000 taxable profit and another that has a $5000 loss, then your net passive income is zero and there is not a tax liability – at least at the federal level. Usually the same for a state, but if each rental property is in a different state you may have a tax liability in one state depending on the details.
But what happens if there is no passive income to offset? Or if the passive losses exceed the passive income? Well, it depends.
The Special $25,000 Allowance
If you or your spouse have active participation in the operation of your passive residential rental property activity you may deduct up to $25,000 of passive losses from your nonpassive income, including W-2, self employment, and investment income (married filing separately has different limitations). Active participation is not the same as material participation. Basically as long as you make some decisions regarding the operation of your residential rental property then you have active participation. IRS Publication 925 has more details on active participation.
But there is a limit to this special allowance. It starts to phase out when your modified adjusted gross income goes above $100,000. It is reduced by 50% of the amount above $100,000. By $150,000 the allowance is reduced to zero.
If your passive losses are above $25,000, or your reduced limit if your MAGI is above $100,000, then you have unallowed passive losses for that tax year. What happens to those unallowed losses? Are the losses lost?
The losses aren’t lost. But it may take time to “use” them. These unallowed passive losses are carried forward to the next year. If you have passive income against which you can apply these passive losses, then they are “used” for the new tax year. But again, if there are any unallowed losses remaining or if you have more unallowed losses, then they carry over to the subsequent tax year. Unallowed losses can keep carrying over until they are used up. But what happens if you sell the property and you’ve never used up the passive losses?
What happens to Unallowed Passive Losses when selling the rental property?
Generally speaking when you dispose of a property that has unallowed (or suspended) passive losses attributed to that property, the unallowed losses are “freed up” and taken on the year of the sale. This can essentially offset some gain due to the sale.
When you have multiple rental properties and treat them as separate activities and you sell one, then that sale generally can “free up” the passive losses for all rental properties. Then all the losses can reduce your tax liability for that year.
If relying on unallowed losses to lower your tax liability you may want to consult a tax professional. What commonly happens is discussed here. There are special criteria in certain situations and those have not been covered here. A 1031 exchange is a special situation which may impact the ability to use suspended passive losses. Dispositions other than sales have not been discussed either and treatment of suspended losses can be impacted by the type of disposition.
As you can see passive losses can be helpful to your bottom line and unallowed passive losses typically provide a tax benefit eventually. It is important to note that this discussion of passive losses was limited to those related to residential rental property directly owned by the taxpayer (or through a disregarded entity). And this was a simplified explanation. Also, some states may (actually some do) treat rental losses differently than the federal government does. It is best to have a more detailed understanding of passive losses than this article provides when preparing tax returns and when tax planning. This article was written for awareness, not to provide tax advice for your specific tax situation.