Money Matters

Money Matters: Can losses on rental properties help reduce your income taxes?

CorrespondentJune 28, 2014 

Q. My wife and I make a nice living and have money to invest each month. We don’t have much faith in the stock market so we thought we’d invest in rental properties. We don’t know much about real estate but we don’t know much about stocks either and figured owning property would be a better fit for us.

We tried to manage it ourselves but we both work full time and have an 8- and a 5-year-old, so that didn’t work very well and we hired a property manager. We’ve owned one rental for a couple of years and after expenses we don’t make a lot of money but we figure by the time we retire the mortgage will be paid off and therefore the income to us will increase substantially.

Earlier this year we bought another property and have had one bad tenant after another; it’s currently sitting empty. We are losing money on this property and have thought about not worrying about it since the losses will help reduce our income taxes on our salaries.

On the other hand, we are wondering whether we should admit this purchase was a mistake and sell. How do we make this decision?

A. If you don’t know much about real estate, hopefully you used a real estate professional to help you determine what properties would make good rentals. If you did seek the advice/input from a real estate professional, I’d pose your question to them and if you located the property on your own, I’d find someone knowledgeable about rentals in that location and ask for their advice.

As for the losses, they may not help reduce your current income taxes. Talk to a tax professional, but the following information may be helpful:

Rental activity is usually considered a passive activity; therefore rental losses may be limited to the passive activity rules. The intent of the passive activity rules is to keep people from deducting losses on their tax return for activities where they have invested money but aren’t involved in the business.

There are two exceptions that will allow you to deduct passive losses from rental real estate each tax year against income from nonpassive sources. Nonpassive income includes wages and portfolio income.

The first exception is if you actively participate in the rental activity. You meet the active participation requirements if you own at least 10 percent of the rental property and you have substantial involvement in managing the rental.

You must be involved in making management decisions or arranging for others to provide services. You don’t have to be involved in day-to-day activities but you should have guidelines in place to show that you participate in decisions such as arranging for repairs, determining rental rates and approving tenants. The loss allowance is limited to $25,000 each year.

If you are what the Internal Revenue Service considers a high-income taxpayer, the amount of loss you are able to deduct may be reduced to zero. The $25,000 loss allowance is phased out by 50 percent of the amount by which your Modified Adjusted Gross Income exceeds $100,000 ($50,000 if married filing separately). Thus, the loss deduction is reduced to zero when your Modified AGI reaches $150,000 (less for MFS).

The second exception that allows you to write off passive losses against nonpassive income is if you or your spouse qualify as a real estate professional.

To qualify, one of you must spend more than 750 hours during the tax year in real property trades or businesses in which you materially participate and more than 50 percent of your personal services during the tax year must be performed in real property trades or businesses in which you materially participate. The limit of $25,000 in losses does not apply to qualified real estate professionals.

You need proof of time spent. The best way to do this is to keep a log which includes the date of service, description of service performed, hours spent, who performed the service and, if asked, how this could be verified.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624

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