 Income tax 2022-2023 reporting rental income expenses and losses limits on rental losses. Let's do some wealth preservation with some tax preparation. Most of this information comes from Publication 527 residential rental property including rental of vacation homes, tax year 2022 you can find on the IRS website, irs.gov, irs.gov. Looking at the income tax formula we're focused on line 1 income. Remember in the first half of the income tax formula is in essence and income statement but just an outline other forms and schedules flowing into these line items one of those the Schedule E. Basically an income statement in and of itself having rental income minus rental expenses. The net rental income flowing into line 1 income of our income tax formula. Limits on rental losses and prior presentation we discussed the idea that the rental income although it's basically a kind of side business and we're going to have an income statement format and structure to it will usually not be reported on the Schedule C. The form or schedule usually used for most sole proprietor type of businesses but rather reported on a Schedule E and part that's going to be so that we can deal with these differences between the rental type of income and the other sole proprietorship type of income such as the losses often time being subject to certain limitations as well as differences in the self employment tax. So now we're going to be focusing in on these limits on losses. Now note from the IRS's perspective they obviously want to be your silent partner when you're generating income so if you have income great the IRS wants a piece of it but if you have losses the IRS doesn't want to be on the hook for the losses to be paying for the losses. They don't want to be paying you they're supposed to be taking some of your money not actually paying you in the income tax system so that's when we have an issue with losses from our perspective if we have losses on the rental income from the taxpayer side I would like to get paid for the losses possibly from the IRS or if not be able to do that be able to take the losses against other income such as W2 income often times we can do that when we think about normal kind of losses with Schedule C losses for example why wouldn't we be able to do that with the Schedule E or rental losses. Typically there's going to be more limitations on the rental activity losses due to the nature of the rental activity and one of those major items being that it's a it could be more passive in nature meaning the property itself is kind of doing the work in a similar situation as investing in like stocks and bonds where you're not really doing anything you just the money's working for you and you're generating income it's not exactly the same with rental property that's why there's some back and forth in the laws and these differences in terms of are you actively participating and not which we will get into but that's one concept that's involved the other concept that makes rental property a little bit different is that we're also oftentimes investing in the rental property not just to get the immediate rental income but also hoping that the rental property itself goes up in value due to the nature of just rental property based on location or something like that which also kind of makes it a little bit different in strategy than other kinds of small businesses which we might have a service business where we're really doing the business for immediate kind of short term income not looking for those long term gains. So you can imagine a situation where an investor in rental property would say I'm going to buy a piece of property I'm going to hope the property goes up in value I'm going to go ahead and take losses on the property hoping that my long term goal is really for the value of the property to go up and then I realize the gain when I sell the property so you have a bit different kind of investment structure okay given that limits on rental losses if you have a loss from your rental real estate activity two sets of rules may limit the amount of loss you can report on schedule E you must consider these rules and in the order shown below both are discussed in this chapter so one you've got the at risk rules so these rules are applied first if there are investment in your rental real estate activity for which you aren't at risk. Now this is less common unless you've got kind of a weird financing structure in other words if you were to purchase a building or something like that that you're going to be renting out a home or something typically just like when you purchase a normal home you're going to take out a loan for it and the home itself will be collateral if you default on the loan usually but if you had some more strange financing structures where you're not at risk for the loan then that's when these rules could possibly kick in so these supplies only if the real property was placed in service after 1986 two this is the rule that's going to be common for a lot of rental property owners and that's the passive activity limits generally rental real estate activities are considered passive activities and losses aren't deductible unless you have income from other passive activities to offset them so passive activities the thing that should come to mind when you hear passive activity is I might be limited on the losses and possibly I might not have to pay self-employment tax which is a big one too but we're focused on the losses there however there are exceptions so excess business loss limitation in addition to at-risk rules and passive activity limits excess business loss rules apply to losses from all non-corporate trades or businesses this business loss limitation is figured using form 461 after you complete your schedule E so any limitation on your result resulting from these rules will not be reflected on your schedule E instead it will be added to your income on form 1040 or 1040 SR and treated as net operating loss so that's kind of similar to loss limitation rules for like a schedule C business so if you have a schedule C business then you don't have these passive activity loss rules but you still might have loss limitations because you don't have like income you have excess losses that you can't be writing off against other income and again the IRS doesn't want to be paying you for taxes so then the question is well if I have more losses then I can get a tax benefit for what can I do with those losses possibly hopefully carry them forward or to some other period where I can get a benefit from them alright so you got the form 1040 1040 SR and treated as net operating loss that must be carried forward and deducted in a subsequent year alright at risk rules you may be subject to the at risk rules if you have a loss from that activity carried on as a trade or business or for the production of income and amounts invested in the activity for which you aren't fully at risk so how could that be you invested in an activity usually when you start a business you're going to have to get capital, get money and how are you going to do that either you take your personal money or you take out a loan or you take out other partners or something equity interest so if you get a loan then you're typically going to be at risk for the loan and if you're buying a significant amount of equipment the banks usually going to want that equipment or a home for example property as collateral in the event that you default on the loan otherwise something funny seems to be happening and there's kind of a weird structure taking place if you're not fully at risk in that situation so losses from holding real property other than mineral property placed in service before 1987 aren't subject to the at risk rules in most cases any loss from an activity subject to the at risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year you are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity any loss that is disallowed because of the at risk limits is treated as a deduction from the same activity in the next tax year you can see publication 925 for a discussion of the at risk rules alright form 6198 if you are subject to the at risk rules file form 6198 with your tax return so the passive activity limits possibly the most likely the more common type of hurdle that we were run into with our losses so in most cases all rental real estate activities except those of certain real estate professionals discussed later are passive activities so we have this question of what does it mean to be passive activity are we actively participating and so on so let's first think about passive activities and we'll get into some more of the weeds on some of that other stuff so once again in most cases all rental real estate activities except those of certain real estate professionals discussed later are passive activities for this purpose a rental activity is an activity from which you receive income mainly for the use of tangible property rather than for services that's why it's kind of passive because the property in essence is doing most of the work you're not getting paid primarily for things that you're doing the sweat off your brow or the stress off your heart or whatever it is when you're doing work these days for a discussion of act of activities that aren't considered rental activities see rental activities in publication 925 deductions or losses from passive activities are limited you generally can't offset income other than passive income with losses from passive activities so that's where the limitation comes into play if you're limited to the losses on passive losses you cannot take them then you would think against W2 income because that would be the ordinary kind of income not passive income you can take a loss of one rental property against another rental property you would think because those are both passive activities so you've got to match out the passive activity losses to passive activity income is the general idea now again this becomes difficult if someone's strategy in investing in rental property which could quite often be the case is to try to generate long term income from the value of the property going up while writing off losses during that time period from the rental property because then you're not going to have any rental income to write off the the losses too and that becomes an issue nor can you offset taxes on income other than passive income with credits resulting from passive activities so any excess loss or credit is carried forward to the next tax year exceptions to the rules for figuring passive activity limits for personal use of a dwelling unit and for rental real estate with active participation are discussed later so we'll get into basically some exceptions we have the exceptions here big exceptions exceptions to the rules for figuring passive activity limits for personal use of a dwelling unit and for rental real estate with active participation becomes a key term there for a detailed discussion of these rules you can see publication 925 real estate professionals meet line 43 of schedule E so you qualify as a real estate professional for tax year if you meet both the following requirements more than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate so most of your work is in real estate and again you can kind of like if you imagine the back and forth from the IRS on this topic then you can see how sausage is made with the tax code here because the IRS you can imagine the discussion here which helps to memorize the things the IRS is saying hey you people mainly rich people are taking advantage of the rental property by writing off losses and then holding on to the property and getting this passive income and getting capital gains from holding the property and whatnot and so we're going to call it all passive income and we're going to say you can't take the losses and you can imagine then people that actually work in the real estate industry are like wait a second I work full time I'm not like a rich person I work full time in real estate and so you're limiting my losses way more severely than people in other types of businesses and then you can see these kind of half well if you're a real estate professional then we'll make an exception or if you actively participate or something and you can see how the back the pendulum swings back and forth here so you perform more than 750 hours of services during the tax year and real property trades or business in which you materially participate okay so if you qualify as a real estate professional then what happens rental real estate activities in which you materially participate aren't passive activities for purposes of determining whether you materially participate in your rental real estate activities each interest in rental real estate is a separate activity unless you elect to treat all your interests in rental real estate as one activity so little bit seems kind of a small thing but could make a big difference again if you qualify as a real estate professional rental real estate activities in which you materially participate for that actual area or that piece of property aren't passive so then the question what if I have multiple pieces of real estate can do I I could say that all of them are grouped together as one real estate kind of activity or I see if I materially participate for each individual property so once again for purposes of determining whether you materially participate in your rental real estate activities each interest in real estate is a separate activity unless you elect to treat all your interests in rental real estate as one activity so don't count personal services you perform as an employee in real property trades or businesses unless you are a 5% owner of your employer you are a 5% owner if you own or are considered to own more than 5% of your employer's outstanding stock or capital or profits interests don't count your spouses personal services determine whether you met the requirements listed earlier to qualify as a real estate professional however you can count your spouse's participation in an activity in determining if you materially participate okay real property trades or businesses a real property trader business is a trader business that does any of the following with real property develops or redevelops it constructs or reconstructs it compares it converts it rents or leases it operates or manages it brokers it choice to treat all active all interests as one activity so if you were a real estate professional and had more than one rental real estate interest during the year you can choose to treat all the interest as one activity you can make this choice for any year that you qualify as a real estate professional if you forego making the choice for you can still make it for a later year if you make the choice it is binding for the tax year you make it and for any later year that you are a real estate professional so once you make that decision make sure you think about it first so this is true even if you aren't a real estate professional in any intervening years for that year the exception for real estate professionals won't apply in determining whether your activity is subject to the passive activity rules so see the instructions for schedule E for information about making this choice material participation generally you materially participate in an activity for the tax year if you were involved in its operations on a regular continuous and substantial basis during the year you weren't just kicking back in your hammock collecting rents you were doing stuff you were doing stuff regular continuous and substantial so for details you can see publication 925 or the instructions for schedule C participating spouse if you are married determine whether you materially participated in an activity by also counting any participation in the activity by your spouse during the year so you can still kind of kick it in the hammock sometimes if your spouse is doing stuff apparently which is nice so do this even if your spouse owns no interest in the activity or files a separate return for the year form 8525 so you may have to complete form 8525 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of passive activity loss of loud on your tax return see form 8582 not required later in this chapter to determine if you must complete form 8582 and then we got if you required to complete form 8582 and are also subject to the at risk rules include the amount from form 6198 line 21 deductible loss in column B of form 8582 worksheet one or two as required okay exception for personal use of dwelling unit so now we've got another somewhat unusual situation or different than the norm we've got the personal use situation so the most clean cut situation is where there is no personal use and you've got a separation of the business property and the personal and then you have a fairly common situation although a more complicated one where you've got a personal use commingling some personal and business alright if you use the rental property as a home during the year any income deductions gained or lost allocable to such to such use is not to be taken into account for purposes of the passive activity loss limitation instead follow the rules explained in chapter five exception for rental real estate with active participation alright here we go with another exception big one here if you or your spouse actively participated in a passive rental real estate activity you may be able to deduct up to 25,000 of loss from the activity from your non passive income who that's a big so again you can imagine the back and forth as if it's useful to imagine just to memorize just to kind of see what's going on if you imagine an arguing match between the iris and people that have rental real estate right the iris says you rich people are taking advantage of these loss limitations and taking these massive losses on property that's appreciated in value where all all rental property is now passive and you don't get any loss deductions and then people that work in the real estate profession are like wait a second I'm barely getting by I'm a real estate professional I'm not a billionaire or anything I'm not you know I'm not making it so you're ripping me off because all these other businesses get to take losses and you're limiting my losses like okay well maybe if you're a real estate professional and you qualify for all this kind of stuff then will allow you some and then some people are like well look I'm not a billionaire billionaire whatever either and I have I have rental property that has legitimate losses I might not actively be a real estate professional meaning I might not spend all my time on the real estate but clearly I'm putting a significant amount of time in it because I got to deal with my tenants I've got to I've got to you know collect the rent I mean the property is doing a lot of the work but clearly it's not like I'm just sitting in my hammock I had to send my spouse out there to collect the rent just kidding but there's clearly participation that happened so then the IRS is like okay we'll give you like 25,000 so they just kind of picked a random number you would think this number would be going up with inflation over the years but they kind of but it hasn't so we'll see what ends up happening in the future with it but in any case big exception if you or your spouse actively participate in a passive rental so I had to cut out there for a bit I had the giggles there for a second anyways this is serious this is serious back to the big exception so if you or your spouse actively participate in a passive rental real estate activity you may be able to deduct up to 25,000 dollars of loss from the activity from your non passive income so this special allowance is an exception to the general rule disallowing losses in excess of income from passive activities similarly you may be able to offset credits from the activity against the tax on up to 25,000 dollars of non passive income after taking into account any losses allowed under this exception example Jane is single and has 40,000 dollars in wages 2,000 of passive income from a limited partnership and 3,500 of passive loss from a rental real estate activity in which she actively participates that's the key term there 2,000 of Jane's 3,500 loss offsets her passive income the remaining 1,500 loss can be deducted from her 40,000 wages in other words notice we're matching up the passive activities here and and we still get to take the loss against her active W2 wages which is which is huge right that's what we want to be able to do so active participation so what does that mean that I've got to qualify for that I've got to do the bare minimum to make sure I get that active participation thing what's the bare minimum so you actively participate in a rental real estate activity if you and your spouse owned at least 10% of the rental property and you made management decisions or arranged for others to provide services such as repairs a significant and bona fide sense so some vague terminology there for the most part but obviously if you're doing your own kind of management of the property you would think that would be pretty clearly active participation if you're hiring someone a management firm to do to do it then it becomes a little bit more elusive you would think to say management decisions that may count as active participation includes approving new tenants deciding on rental terms approving expenditures and other similar decisions example Mike is single and have the following income and losses during the tax year salary $42,300 dividends $3,000 interest $1,400 rental loss $4,000 the rental loss was from the rental of a house Mike owned Mike had advertised and rented the house to the current tenant himself also collected rents which usually came by mail all reports all repairs were either made or contracted out by Mike so obviously in this situation Mike is actually doing a fair bit of work he's not doing his full time job may not be but he's still that could take quite some time to do that kind of stuff to manage that kind of stuff and therefore you would think they're actively participating and you would think some losses would be attributable possibly in that instance so although the rental loss is from a passive activity because Mike actively participated in the rental property management he can use the entire $4,000 loss to offset his other income which is great we might be able to take the loss and offset it against like W2 income for example maximum special allowance the maximum special allowance is $25,000 for single individuals and married individuals filing a joint return for the tax year now that might look funny it is kind of funny because again this this back and forth that resulted in this $25,000 that doesn't seem to be increasing yearly on inflation and it's not changing with regards to a single filer and a married filer is a little bit weird it's a little bit odd because you would think if it was $25,000 for single that if you were married it would be doubled that would be otherwise you know that's what they do with a lot of other stuff so it's kind of weird that it's the same but it is what it is what $12,500 for married individuals who file separately so notice if you're single you get the $25,000 if you're married you can choose to file married filing joint or married filing separate if you choose married filing separate then it breaks down to $12,500 that's different from single where it's still at the $25,000 or head of household $25,000 $12,500 for married individuals who file separate returns for the tax year and lived apart from their spouses at all times during the tax year and $25,000 for a qualified estate reduced by the special allowance for which the surviving spouse qualified okay if your MAGI modified adjusted gross income is $100,000 or less $50,000 or less if married filing separately so again we've got this limit for $100,000 in general not $50,000 if you step back down to single or head of household but if you're married filing separately you can deduct your loss up to the amount specified above so if your MAGI is more than $100,000 more than $50,000 if married filing separately your special allowance is limited to 50% of the difference between $100,000 between $150,000 $75,000 if married filing separately and your MAGI so it starts to phase out in other words so that's a key component because if you're talking about people that have rental property it could quite be possible that they've cleared the $100,000 and start to phase out on that $25,000 so you want to know that number when you're doing your long-term planning when you're starting to plan your millions that you're going to be earning or whatnot so generally MAGI is $150,000 or more $75,000 or more if married filing separately there is no special allowance so once you clear $150,000 the phase out is from $100,000 to $150,000 then after $150,000 you lose the $25,000 no more getting the losses what? that's horrible modified adjusted gross income MAGI this is so when we think about the AGI phase outs we think about the adjusted gross income and then modifications which are usually slight modifications for your phase out to the AGI on page one of the form 1040 this is your adjusted gross income from form 1040 1040 SR, 1040 NR line 11 figured without taking into account one, the taxable amount of social security or equivalent tier one railroad retirement benefits if that's applicable to you these are the modifications that could come into play for certain people two, the deductible contributions to traditional individual retirement accounts IRAs section 105C 18 pension plans those could be significant three, the exclusion from income of interest from series EE and IUS saving bonds used to pay higher education expenses four, the exclusion of amounts received under an employer's adoption assistance program five, any passive activity income or loss included for form 8582 six, any rental real estate loss allowed to real estate professionals seven, any overall loss from a publicly traded partnership see publicly traded partnership PTPs and the instructions for form 85828 the deduction allowed for one half of self employment tax nine, the deduction allowed for interest paid on student loans and ten, the deduction allowed for form derived intangible income and global intangible low taxed income so you want to know the general rule in practice obviously software can help you with these modifications hopefully when doing the actual calculation form 8582 not required don't complete form 8582 if you meet all the following conditions your only passive activities were rental real estate activities in which you actively participated your overall net loss from these activities is 25,000 or less 12,500 or less if married filing separately and you lived apart from your spouse all year if married filing separately you lived apart from your spouse all year you have no prior year unallowed losses from these or any other passive activities you have no current or prior year unallowed credits from passive activities your MAGI is 100,000 below the threshold or less 50,000 blah blah married filing separately you don't hold any interest in a rental real estate activity as a limited partner or as a beneficiary of an estate or a trust if you meet all the conditions listed above your rental real estate activities aren't limited by the passive activity rules and you don't have to complete form 8582 online 23a through 23e of your schedule enter the applicable amounts alright