Active Participation Rental Real Estate
For tax purposes, rental real estate activities are generally considered "passive activities." This means that losses from these activities can typically only be deducted against passive income (income from other passive activities). However, the IRS provides a special allowance for individuals who "actively participate" in their rental real estate activities, allowing them to deduct a limited amount of passive losses against non-passive income, such as wages or self-employment income.
Requirements for Active Participation
To qualify for active participation status, you generally need to meet the following criteria:
Ownership Interest: You (and your spouse, if filing jointly) must own at least a 10% interest (by value) in the rental activity throughout the entire tax year.
Management Decisions: You must participate in making management decisions or arranging for others to provide services in a "significant and bona fide sense." This is a less stringent standard than "material participation" (which is required for real estate professionals). The IRS states that "management decisions that count as active participation include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions." You are considered to actively participate if you make decisions which significantly affect how the business is managed. You cannot, however, actively participate if at any time during the year your interest (including your spouse's interest) in the activity was less than 10% (by value) of all interests in the activity, or if you are a limited partner in the activity.
It's important to note that simply owning the property and collecting rent is not enough. You need to demonstrate actual involvement in the operational and management aspects. While you don't need to be involved in the day-to-day operations as intensely as someone meeting "material participation" standards, you must still be actively engaged in significant decisions.
Benefits of Active Participation
The primary benefit of achieving Active Participation Rental Real Estate Status is the ability to deduct up to $25,000 in passive rental losses against non-passive income (like your salary or business income) each year.
Here's how this benefit works and its limitations:
Offsetting Non-Passive Income: If your rental expenses (e.g., depreciation, mortgage interest, repairs, property taxes) exceed your rental income, you generate a passive loss. With active participation, you can use up to $25,000 of this loss to reduce your taxable income from other sources.
Example: If you have a $20,000 rental loss and a $90,000 salary, your taxable income could be reduced to $70,000 ($90,000 - $20,000), leading to significant tax savings.
Modified Adjusted Gross Income (MAGI) Phase-Out: The $25,000 allowance is subject to a phase-out based on your Modified Adjusted Gross Income (MAGI).
The allowance begins to phase out when your MAGI exceeds $100,000. For every $2 your MAGI is over $100,000, the $25,000 allowance is reduced by $1.
The allowance is completely eliminated when your MAGI reaches $150,000.
Suspended Losses: If your losses exceed the $25,000 allowance (or the phased-out amount), the excess losses are "suspended" and carried forward indefinitely. These suspended losses can be used in future years to offset passive income or are fully deductible in the year you dispose of (sell) the rental property.
Distinction from Real Estate Professional Status: Active participation is a lower bar than qualifying as a "Real Estate Professional." Real Estate Professionals (who meet much stricter hour-based tests) can deduct all their rental losses against any type of income, without the $25,000 limit or MAGI phase-out. Active participation is a more accessible status for many individual rental property owners.
In essence, active participation status provides a valuable tax break for rental property owners who are genuinely involved in the management of their properties, allowing them to reduce their overall tax liability by offsetting rental losses against other income sources.
