8021 / What amount of passive losses (and the deduction-equivalent of credits) from rental real estate activities may an individual deduct against nonpassive income?

First, while few investors in real estate syndications will qualify for this exception, it should be noted that certain rental real estate activities may not be subject to the passive loss rules. For tax years beginning after 1993, a rental real estate activity of a taxpayer is not automatically considered a rental activity subject to the passive loss rules for a year, but only if during the year (1) more than one-half of the personal services performed by the taxpayer in trades or businesses during the year is in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of service during the year in the real property trades or businesses. See Q 8022.

An individual can deduct losses (and the deduction-equivalent of credits) attributable to all rental real estate activities subject to the passive loss rules in which he or she has “actively participated” (and has at least a 10 percent interest in the activity at all times during the year) against as much as $25,000 of nonpassive income.¹ The $25,000 amount is reduced by 50 cents for each dollar by which the individual’s adjusted gross income exceeds $100,000.² Adjusted gross income, for this purpose, does not include Social Security or railroad retirement benefits, is not reduced by contributions to an IRA, any passive loss or loss from rental real estate with material participation, deductions for student loan interest, deductions for qualified tuition and related expenses (see Q 8054), or deductions for production of income, and is not reduced by the exclusions for savings bonds interest used to pay higher education expenses (see Q 7686) or certain adoption assistance programs.³

The rules above are applied differently to deductions of amounts equivalent to the low income housing credit (see Q 7801) or the rehabilitation credit (see Q 7808). First, the requirement that the individual own at least a 10 percent interest in the activity and “actively participate” does not apply to these deductions.⁴ Furthermore, with respect to the rehabilitation credit, the $25,000 amount does not begin to phase out until the individual has adjusted gross income of $200,000 instead of $100,000.⁵ With respect to property placed in service after 1989, there is no phase-out of the $25,000 rental real estate exemption with respect to the low-income housing tax credit.⁶ For property placed in service before 1990, the $25,000 exemption amount for rental real estate with respect to the low-income housing tax credit did not begin to phase out until a taxpayer had income in excess of $200,000.

The $25,000 amount is not available to married individuals who file separately but who did not live apart at all times during the year. For married individuals who file separately and did live apart at all times during the year, the $25,000, $100,000, and $200,000 amounts are cut in half (i.e., $12,500, $50,000, and $100,000).⁷ For up to two years after a decedent’s death, an estate may offset up to $25,000 (subject to the phase-out rule) of nonpassive income with passive losses and credits from a rental real estate activity in which the decedent actively participated before his or her death. The estate’s $25,000 amount is reduced by the rental real estate exemption amount that would be allowable to the surviving spouse calculated as if the spouse were not subject to the phase-out rule.⁸

The $25,000 rental real estate exemption is available with respect to a publicly traded partnership subject to the passive loss rule (see Q 8010) only to the extent that the low-income housing credit and the rehabilitation credit exceed the regular tax liability attributable to income from the partnership.⁹

The term “publicly traded partnership” means any partnership if (a) interests in such partnership are traded on an established securities market, or (b) interests in such partnership are readily tradable on a secondary market (or the substantial equivalent thereof).¹⁰

Before passive losses from a rental real estate activity can be used to offset nonpassive income, they must first be netted against other real estate activities in which the taxpayer actively participates, then against other passive income. Any remaining losses may be applied against up to $25,000 of nonpassive income. If losses are otherwise deductible under the $25,000 rule, but the taxpayer cannot deduct all or part of them in the current year because passive losses exceed the taxpayer’s nonpassive income, the excess losses are treated as a net operating loss arising in that year which can be carried back and forward in accordance with the net operating loss rules.¹¹ With regard to the interaction of the passive loss rule with other limitations on the use of credits or the deductibility of losses, see Q 8017 and Q 8018.

An individual must actively participate in the rental real estate activity and have at least a 10 percent interest in the activity at all times during the year in order to take advantage of the $25,000 exemption amount (unless the individual is claiming the deduction equivalent of the low income housing or rehabilitation credit, as noted above). Except as provided in regulations, a limited partner is not treated as actively participating with respect to a limited partnership interest.¹² A taxpayer can meet the active participation requirement by making management decisions, such as “approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions,” and arranging for others to provide services such as repairs. Regular, continuous, and substantial involvement in operations is not required. In determining whether a person actively participates, the participation of a spouse is considered. In determining what an activity is, it may be necessary to consider the degree of business and functional integration among different properties or units of property.¹³ For a definition of “active participation,” see Q 8020.

The rule allowing up to $25,000 of rental real estate losses and credit-equivalents to offset nonpassive income does not apply to losses and credits carried over from a year in which the taxpayer did not actively participate. Credits and losses that were disallowed in a prior year, because they exceeded the rental real estate exemption amount in that year, are only deductible under the $25,000 rule if the taxpayer actively participates in the year to which the losses and credits are carried over.¹⁴