Tax Director Charles Jenkins Jr, CPA answers the question "Can I use a rental property loss to offset my ordinary income?" by looking at the types of income defined by the IRS, and how they interact with each other. Don't feel like watching? Read on below.
In thinking through tax savings strategies, you may have asked yourself if you can use a rental property loss to offset your ordinary income. This may seem like a straightforward question, but the answer is not black and white. Like many other questions related to tax, the answer is: it depends.
Let’s first acknowledge that this is a very complex area of tax law. We will walk through a few high-level concepts together, and by the end you will have a better understanding of factors you need to consider when investing in real estate as a tax saving strategy.
Types of Income
The IRS delineates two types of income: non-passive income from material participation work, and passive income from non-material participation work. It’s crucial to identify the difference between the two and understand how they interact with one another.
Material participation could be your W-2 job or a small business that you own and operate. Material or active participationin work generates what is considered non-passive income to you as a taxpayer in the eyes of the IRS.
On the other hand, non-material participation or participation inpassive activitiesgenerates passive income according to the IRS. This would include K-1 investments in other companies that you’re not personally involved with. Rental properties fall into this passive income category, unless certain qualifications set by the IRS are met.
How The Types of Income Interact
Whether or not you can deduct passive non-material losses is the question at hand. To determine the answer, we will look at the two types of income sources and determine how and when you can use losses in both categories.
Generally speaking, if you have income or losses in the category of non-passive income (items that you materially participate in), you can use those losses to offset income from other sources in the non-passive income category AND from sources in the category of passive income.
The same does not hold true for the losses in the passive category of income. In these cases, you can ONLY use income or losses in the category of passive income to offset income from other passive sources of income. Therefore, if you have rental real estate losses you must have other passive sources of income to utilize those losses in any given year.
To sum this up, the answer to the original question is that you cannot use a passive rental property loss to offset income from your W-2 or small business that you run day to day.
Exceptions and Other Considerations
Just because you can’t use a loss to offset income doesn’t necessarily mean that it goes away. If you can’t utilize a loss in the current year, it will carry forward in that same category. For example, if a rental property or a K-1 generates significant income in a future year, then a rental loss can carry forward to offset that income in that future year.
Alternatively you might be able to use those losses if your primary job is in a profession that involves real estate. If you actively participate in rental properties, there is a chance that you might be able to utilize losses in any given year to offset some other non-passive income. If you actively participate in rental property and your overall income is below a certain threshold in any given year, the IRS will allow you to deduct some of those losses.
Another point to consider is “business use” verses “personal use” of your rental properties. Owning a rental property solely for the business purpose of generating income helps simplify your potential tax benefits regarding that investment. If however, a rental property that you own is a ski lodge that you and your family use occasionally throughout the year, then you will need to take the ratio of business time verses personal time into account. If the personal use percentage is too high and crosses certain IRS designated thresholds, then not only will you not be able to use that loss in the current year, but the loss cannot be carried forward to a future year.
The last point to consider is the type of rental property in question. Is it a commercial rental property or a residential rental property? If it is residential, the IRS has further stipulations as to whether it is used as a long-term rental or a short-term Airbnb or VRBO type of rental property. The rental property type is going to dictate the useful life on some potential depreciation possibilities, and it will also affect some of the tax deductions allowed on improvements you make.
"It depends,” can be a frustrating answer, but the specific and complex nature of the tax law requires a deeper understanding of your objectives for your real estate investment. Intentional planning is required to properly use tax deductions gained from rental properties to offset other sources of income. We highly recommend speaking with your tax professional or reaching out to us here at Dillon Business Advisors to ensure that you have a solid plan in place.
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