How To Qualify For A Real Estate Tax Deduction Against Nonpassive Income
There are still ways to claim a real estate tax deduction that can be used to shelter other non passive income you have earned during a tax year. However, since Congress passed the Tax Reform Act of 1986, the amount that can be deducted is limited to a maximum of $25,000 per year, among other restrictions.
In general, rental real estate activities are considered passive activities for tax purposes. Therefore, any losses from passive activities can only be deducted from income earned through other passive activities. The simplified explanation is that you can only deduct losses from your real estate investments from income earned from other real estate that you hold, with one exception.
Real Estate Tax Deduction Exception
If you have "materially" or "actively" participated in your rental real estate activity, you just might be able to deduct up to $25,000 of any losses incurred, from your other nonpassive income (wages, salary, interest, dividends etc.) In order to claim the full $25,000 deduction, your "Modified Adjusted Gross Income" (MAGI) for the year must be less than $100,000. Once your MAGI reaches $150,000, you no longer qualify for the exemption. If your income is between $100,000 and $150,000, the maximum exemption you can claim is 50% of the difference between your MAGI and $150,000.
Material Participation - If you were involved in the operations of a rental real estate activity on a continuous, substantial and regular basis, you are considered to have materially participated in the activity.
Active Participation - To have actively participated in a rental real estate activity you must have met two criteria. 1. You owned at least 10% of the rental property and 2. You participated in the management decisions of the property in a significant and bona fide sense. ie. determining rental terms, screening new tenants, budgeting and approving expenses etc.
Modified Adjusted Gross Income - On Form 1040, line 38 you will find your adjusted gross income. Your modified adjusted gross income is this amount but without taking into account things like deductible contributions to your IRA or other retirement plans.
An example of a real estate tax deduction using the $25,000 exemption:
Rick is a single guy. The following represents his income and losses for the year:
Rental Loss (his share): ($15,000)
Rick owned 50% of a 20 unit apartment building. He screened all new tenants, set the rental rates, and approved all expenditures, among other duties. Because of this involvement, and the fact that he owned at least 10% of the rental property, he was considered to have actively participated in the rental property. Now, let's determine the amount of the real estate tax deduction he qualifies for.
For simplicity sake we will assume that Ricks's MAGI is $122,500. Therefore, the maximum deduction he can claim is $150,000 less $122,500 X 50% = $13,750. (Note that because Rick's MAGI was greater than $100,000 he did not qualify for the full $25,000 exemption and therefore can only deduct $13,750 of the $15,000 in real estate losses from his non passive income.)
So what happens to the remaining $1,250 of the loss? He can either carry this amount over to the next tax year or use it to reduce his taxes when the apartment building is sold. In other words, he will be able to use that real estate tax deduction at some point in the future, just not this year.
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