The IRS treats rental losses differently for investment properties and trade properties.
The IRS uses different loss rules to limit the types and amount of losses deducted for rental properties. The tax savings realized through a tax loss may be used to offset income such as self-employment income or alimony. The loss is deducted against gross income and may produce a net operating loss. Using carry-back rules, the loss may be carried backward or forward, depending upon the offset of income and tax deductions the taxpayer claims.
Casualties and Thefts
If the taxpayer suffered a theft or casualty during the tax year that damaged his property, he may deduct the loss on income tax returns. A casualty is defined as a sudden and unexpected event, such as an earthquake. A theft is the unlawful appropriation of the taxpayer's property with the intent to permanently deprive the taxpayer of that property. Any insurance proceeds above the fair market value of the property must be included as a gain.
Loss From Sale
A real estate loss may occur when the taxpayer sells the home for less than she paid for it. The cost of improvements is added to the basis or base price of the home. The taxpayer must account for any tax deductions and repair deductions taken during the entire rental period. Once all of these factors are considered, the taxpayer may actually have profited from the sale.
Passive Losses
Real estate rental losses are generally treated as passive losses unless the taxpayer is considered a real estate professional or in the real estate business. If the business profits do not generate income for professional services but produce only real estate rental income, the IRS will treat it as a "passive loss."
Losses that are considered passive may require the taxpayer to defer or suspend the losses for a given year. Unless the taxpayer has net income for a tax year from the rental activities, she may not deduct the loss. However, selling a rental property triggers an exception to the passive loss rule and suspended passive losses are deductible once the home is sold.
Active Loss or At-Risk Loss
This rule will apply when the taxpayer has suffered a loss through a business activity used to produce income. If the taxpayer is in the business of renting properties as his trade or business, the losses may offset income. The losses that are included under this rule are limited to the amount risked within the rental business.
Real estate professionals who conduct at least 750 hours of annual service in real property businesses or trades are considered active participants. Service may include brokerage, licensing, developing or building real estate.
Active Losses Exception to Passive Loss Rule
If the taxpayer actively participated in the real estate activity that is generally treated as a passive loss, the federal tax regulations provide an exception to the rule disallowing passive income losses. Taxpayer who actively participated in generating or trying to generate rental income may deduct up to $25,000 for losses.
Disclaimer
Since laws frequently change, you should not use this information as a substitute for legal advice. Seek an attorney's advice licensed to practice in your jurisdiction.
Tags: real estate, offset income, passive loss, actively participated, deduct loss, estate rental, generally treated
