Duvall & Associates, Inc.
BUSINESS ADVISOR NEWSLETTER
 

Finer points on rental properties, tax law

- by Alan Duvall 

Published in Dayton Daily News January 22, 2006  

Shakespeare’s Juliet purred to Romeo, “What’s in a name?  That which we call a rose by any other word would smell as sweet.” 

When it comes to rental property, the IRS sometimes takes a different approach.

Federal tax law classifies real estate rental properties as either active or passive activities. Except for business self-rentals, which could go either way, depending on how much money they generate.

Rentals are classified as active if the owner performs extraordinary personal services with regard to the property.  Special rules for vacation rentals also exist.  Losses from active rentals are fully deductible.   

This stringent test throws most real estate rentals into the passive category.  The ability to deduct losses from passive rentals is very limited.   

If a taxpayer does not participate at all in the passive rental – losses can only be deducted against the income of other passive rentals.  Unused losses are carried forward to future years, deductible against passive incomes of other rentals or the subject property. 

If a taxpayer “actively” participates (a test less stringent than the above extraordinary service test) in a passive real estate rental, up to $25,000 losses can be annually deducted, so long as owner adjusted gross income (AGI) is less than $100,000.   If owner's AGI is more than $100,000 - deduction is further limited by a formula until zeroed out at $150,000. 

For legal purposes, business owners often place owned buildings in an entity separate from their business.  The building is then leased to the business. 

The IRS correctly concluded owners could potentially manipulate such self-rentals to create positive income that, if treated as passive, could be used to deduct otherwise limited passive losses.  So the IRS generally classifies such rental income as active. 

Enter Shakespeare’s rose test.  If the business self-rental yields net losses, the IRS may treat the rental as passive and so limits loss deduction. 

Self-rental tax savings may be tax killed either way.  Net income is active and taxed.  Net losses are passive with limited deduction. 

And if a self-rental building yields losses one year, income the next, then losses?  The IRS could treat the building as passive, active, passive in successive years. 

Alan Duvall is a certified public accountant in Dayton.  Contact him at Alan@Duvallcpa.com.