When dealing with rental property income tax, the amount of tax you owe and the deductions you can claim depend on your level of involvement in running the property. The IRS classifies rental income as “passive,” which generally prevents using rental losses to offset other income like salary, unless certain criteria on active involvement are met.
In this article, we explain how those factors determine your tax obligations.
What Is Passive Income and Why Does It Matter?
First, you should know the IRS considers rental income passive, meaning any losses from your rental property are usually passive losses. Normally such losses can only be used to reduce passive income, like income from another rental or a business you don’t actively operate.
However there are two exceptions for rental property owners, which let you use rental losses to minimize taxes on non-passive income like wages, depending on whether you actively or materially participate in managing the property.
Active Participation: The $25,000 Deduction
Active participation is the easier of the two categories. If you actively oversee your rental property, you might be able to deduct up to $25,000 in rental losses from your other income, like your salary.
This can be helpful if your rental isn’t making much money and you want to cut down your taxable income from other sources. To qualify for active participation, you need to meet certain requirements:
Ownership – You must own at least 10% of the property.
Management involvement – You need to make key management decisions like setting rental terms, approving tenants, and managing expenses. You don’t need to do everything yourself, but you must be actively involved in making these decisions. You can’t just leave it all to a property manager.
Income Phase-out for Higher Earners
One limitation of the active participation deduction is that it falls as your modified adjusted gross income (MAGI) goes over $100,000. For those earning more than $150,000, the deduction is completely gone. This means higher earners won’t get that benefit.
Material Participation: More Involvement, Bigger Benefits
Material participation requires more hands-on involvement than active participation. If you qualify for material participation, you can use rental property losses to reduce not just passive income, but also ordinary income like wages, salary, or business income.
To qualify for material participation, you need to be heavily involved in managing and running your rental property. The IRS has a few tests to determine if you meet this requirement, but the key test is that you must spend at least 500 hours per year actively working on your rental property. This can include tasks like managing tenants, handling maintenance, or making decisions related to the property.
Real Estate Professional Status
For people in the real estate business, there’s a special classification known as a real estate professional. This status is especially beneficial because it allows real estate professionals to treat their rental activities as non-passive, meaning their rental losses can offset other types of income without restrictions. To qualify, you must:
– Spend more than 750 hours per year on real estate activities.
– More than 50% of your working time must be dedicated to real estate activities.
Material vs. Active Participation: Which One Benefits You More?
The key difference between active participation and material participation is how involved you need to be. Material participation has bigger benefits because it lets you use rental losses to slim ordinary income, not just passive income.
However, it’s harder to qualify for material participation. It requires a lot of time and effort. If you’re not working full-time in real estate, this might be tough to meet. On the other hand, active participation is easier to qualify for and can still provide solid tax savings, especially if you have rental losses and earn an average income.
Which Participation Standard Should You Aim For?
If you’re a rental property owner trying to make the most of tax benefits, the choice between active and material participation depends on how much time you’re willing to invest in overseeing your properties.
Active participation is a good option if you want tax savings without dedicating a lot of time to looking after your property. With active participation, you can still get a $25,000 deduction, which can be quite valuable if your income is moderate. It’s the easier option to qualify for and requires less effort.
Material participation, on the other hand, is better suited for those who are deeply involved in real estate, whether as a hobby or a career. It allows you to use rental losses to offset not just passive income, but also ordinary income, providing a bigger tax benefit. However, it requires significant time and a more active role in property management.
Conclusion: Make the Most of Your Rental Property Deductions
Qualifying for either active or material participation can make a big difference in how your rental property income and losses are treated for tax purposes.
If you’re uncertain about which category you fall into or need guidance on planning your rental property taxes, consult with a tax professional.
