Written By: Kevin Jerry / April 29, 2024

LIMITS ON RENTAL LOSSES

Cost segregation is a phenomenal strategy for reducing taxable income in the current tax year. 

However, in some instances, cost segregation just doesn’t make sense. If the segregated property is subject to the passive loss rules, much of the additional depreciation generated may not be able to be used in the current year and is suspended for use in subsequent years. The fees for the cost segregation study will need to be paid upfront, but the tax benefit may not be able to be used until future years.

This is generally not a good use of capital. This is why it’s essential to choose a cost segregation company whose representative understands the tax code. Most often, an uneducated rep will assume the additional depreciation is non-passive, and it often is NOT.

The following rules will limit the loss deductions allowed on a rental real estate activity.

• At-risk Rules: Generally, the IRS allows any loss from an activity only to the extent of the total amount that is at risk at the end of the tax year.
• Passive Activity Limits: The IRS generally considers rental real estate activities passive activities, and a loss is not deductible unless income from another passive activity exists to offset it. The taxpayer may carry any excess passive activity loss or credit forward to the next tax year.
• Real Estate Professional Status: A passive rental loss can offset ordinary income if BOTH of the following two exceptions are satisfied.
  1. More than half of all personal service time (work time) is involved in real property trades or businesses in which the taxpayer materially participates.
  2. More than 750 hours of material participation in real property trades or businesses.

If rental losses are not more than $25,000, and the taxpayer or spouse actively participates in the rental activity, the passive activity limits may not apply. Active participation is a less stringent standard than material participation. Active participation includes management decisions such as approving tenants, rental terms, approving expenditures, etc.

This special allowance is an exception to the general rule, disallowing losses in excess of income from passive activities.

Of course, there are qualifications for this exception. If a taxpayer has modified adjusted gross income (MAGI) of $100,000 or less, the loss is deductible up to $25,000. If MAGI is more than $100,000, the $25,000 special allowance is limited to 50% of the difference between $150,000 and MAGI. There is no allowance if MAGI is more than $150,000.

HOW MAGI IS CALCULATED

Adjusted gross income is figured without including the following:

1. The taxable amount of Social Security benefits.
2. The deduction allowed for contributions to IRAs or specific other qualified retirement plans. See my previous blog on Qualified Pans.
3. The interest from Series EE and U.S. savings bonds.
4. The exclusion of amounts received under an employer’s adoption assistance program.
5. Any passive activity income or loss included on Form 8582.
6. Any rental real estate loss allowed to real estate professionals.
7. Any overall loss from a publicly traded partnership.
8. The deductions allowed for self-employment tax and student loan interest.

Here is an example:  Paul and his wife manage the daily activities of his 20-unit apartment building. He collects rent and is on-site for all repairs. Paul does not use a Management Company. The loss from his rental activity because of cost segregation is $50,000. They also own a separate partnership generating $5,000 in passive income. MAGI is $125,000. They actively participate in the rental activity and can deduct $12,500 (50% of the difference between MAGI and $150,000) against ordinary income on a jointly filed return. The remaining $27,500 is a passive loss. They can use $5,000 of that loss in the current year against other passive income and may carry forward the remaining $22,500 into the following year.