When it comes to deducting real estate losses on your taxes, the IRS has a bazillion tax rules and regulations.
In today’s post, I’ll help you sift through those regulations and provide you with five tax strategies you can use to deduct real estate losses and reduce your tax bill.
What are real estate losses?
Before we get down to business, I want to first clarify what “real estate loss” means in the tax world. Basically, real estate losses occur when your property’s expenses exceed its income. This can be due to mortgage interest, property taxes, depreciation, maintenance costs, or other expenses necessary to maintain the property.
Within the IRS regulations for real estate losses, the words “passive” and “active” are tossed around like confetti. What you need to keep in mind is that real estate losses are often considered passive, and in most cases, your ability to deduct those losses depends on your income level and your level of participation in buying, selling, or managing that property.
There are also two main types of losses:
- Passive Losses: This type of loss happens when you’re not actively involved with managing the property (more about what that means later). In most cases, the IRS greatly limits the deductions allowed for passive losses.
- Active Losses: This type of loss happens when you’re participating in managing the property. In general, if you meet certain income limitations (which we’ll also talk more about in a minute), then you may be able to deduct real estate losses up to $25,000 each year.
Can I deduct real estate losses on my taxes?
It depends. I wish I could give you a more definitive answer, but really, there are lots of factors to consider when determining if you can deduct real estate losses. Instead, I have created the list below of the five most common and useful tax strategies you can employ to deduct real estate losses.
What tax strategies can I use to deduct real estate losses?
Tax Strategy #1: Active Participant $25,000 Exception
In general, you cannot deduct passive real estate losses. However, there is one main exception.
You can deduct up to $25,000 in real estate losses if you or your spouse actively participate in managing your property and your modified adjusted gross income (MAGI) is $100,000 or less. You can qualify for this deduction as long as you or your spouse own at least 10% of the property.
If your MAGI is more than $100,000, then the deduction phases out. And if your MAGI is more than $150,000, then there’s no deduction available.
Tax Strategy #2: Augusta Rule
This strange tax law allows anyone with a personal residence to rent their property to a business and not pay taxes on the rental income. The main rule here is that the home can only be rented for 14 days or less during the year.
Also, if you own the property being rented and you own the business renting the property, then those tax savings can really add up! This is because your business can write off the rental amount as a business expense and then you won’t have to pay taxes on that income on your personal return.
One thing to note in this scenario is that the property you’re renting to your business can’t be used as your primary place of business the rest of the year, and it must also be used as your personal property for more than two weeks during the rest of the year.
If you’re considering this strategy, you’ll want to read my full post on how to do it.
Tax Strategy #3: Real Estate Professional Status
If you or your spouse meet the requirements for obtaining real estate professional status, you can use depreciation losses from your real estate properties to offset your income, which can drastically reduce your tax bill.
In the tax world, having real estate professional status means that you or your spouse have met all three of these requirements:
- More than 50% of the work you performed during the year was in a real estate trade or business you own, and
- You performed at least 750 hours of services in a real estate trade or business you own, and
- You “materially participated” in each real estate activity used to deduct real estate losses.
The IRS has a pretty open definition of what types of businesses can be used to meet the real estate requirement. By their definition, a real estate trade or business is any business where you develop, redevelop, construct, reconstruct, acquire, convert, rent, lease, operate, manage, or broker real estate.
However, what the IRS counts as providing services is limited to activities that show active participation and are not related to a more passive investing role. For instance, showing properties and preparing leasing paperwork would count towards your 750 hours, but researching properties, driving to and from properties, or preparing financial paperwork for yourself would not.
Additionally, you must “materially participate” in each property that you’ll be using for this strategy, which means you can’t just pay a management company to take care of the property. It also means you have to meet one of a separate list of requirements that determines your level of involvement in a property. If you own more than one property, you can also elect to group them together, which might help meet the material participation requirement.
Another important note here is that you can’t count time spent as an employee towards meeting your real estate professional status unless you own at least 5% of the real estate business where you’re also an employee.
In my experience, this strategy works best for married couples because the requirements don’t allow for you to combine your hours. It’s either you or your partner have met the requirements for real estate professional status. So if the real estate you’re managing is a “side gig” for both of you, then it’s very difficult to meet the time requirements.
As you can imagine, it’s important to keep accurate time logs if you choose to employ this tax-saving strategy. It’s also very important that you speak to a CPA about all of the requirements before you get started.
Tax Strategy #4: Short-Term Vacation Rentals
This strategy applies to vacation properties that you own but that you don’t utilize for personal use. If, on average, you rent this type of vacation property for 7 days or less at a time and you materially participated in the property, you can deduct real estate losses from that property.
Don’t forget to consult an accountant to make sure you’re meeting the requirements and have a plan in place for proving so if you happen to be audited. If you’ve met the requirements, then your real estate losses can be deducted.
Tax Strategy #5: Short-Term Vacation Rentals with Substantial Services
This strategy applies to vacation properties that you own and that are rented, on average, less than 30 days at a time. To employ this strategy, you must also provide what the IRS deems “substantial services” with the rental of the property.
The IRS defines substantial services as “regular cleaning, changing linens, or maid service” that you provide to renters. These services must be provided frequently and must account for a significant part of the amount paid for the rental. Typically, the services should account for at least 10% of the rate being charged for the rental.
Additionally, services that are provided to maintain lawful use of the property, to repair the property, to maintain or clean any public areas of the property, and other similar services are not included in the substantial services umbrella.
If these requirements are met, the real estate losses can be deducted.
Abridged by Amy
If you own real estate, you should take the time to understand how you can potentially benefit from deducting real estate losses on your taxes. Work with an accountant to determine if your income level or property type can unlock deductions, and make sure to keep detailed time and financial records for any properties that you rent.
