Taxpayers who are not actively involved in their real estate rentals cannot deduct their losses against other income. However, taxpayers who are actively involved in their rental endeavors may be able to deduct some or all their losses. These taxpayers are limited to deducting $25,000 or less of their rental losses against other income. Taxpayers with incomes of $100,000 and above have the $25,000 loss allowance reduced until completely phased out at the $150,000 income level. Therefore, taxpayers with incomes exceeding $150,000 cannot deduct any losses unless they are classified as Real Estate Professionals under the tax law.
Real Estate Professionals, as defined by the IRS, can deduct all their passive rental losses against their non-passive income. To be a real estate professional, a taxpayer must 1) spend more than one-half of his or her working time in real property trades or businesses in which he or she materially participates and 2) work more than 750 hours during the tax year in real property trades or businesses.
In general, a real estate professional must establish material participation in each rental activity separately. However, a real estate pro may elect to aggregate all his or her interests in rental real estate for purposes of determining material participation. This requires an IRS election to be filed on an annual basis.
The IRS has been successful in court when challenging real estate pro status. Primarily, because the taxpayers don’t have adequate records proving time spent in their real estate activities.