This is the second question and answer of a three-part series.
Part 2 - How do passive loss limitations affect me?
In our first part, we discussed the backdrop to how rental properties can be a tax shelter (e.g., they have to lose money).
Ok- let’s presume that you have a rental loss. How does it affect your tax return? Rental income is typically considered passive, meaning that you are not directly earning the income as you would with a job. Passive losses may be deducted from non-passive income such as wages, but there are limits. Passive loss limits max out at $25,000, and that number decreases as your gross income increases. Specifically, passive loss reduces $1 for every $2 over $100,000 adjusted gross income, and by $150,000 (for married couples) the passive loss deduction is $0. Bummer.
Not all is lost however. If your rental losses are capped or disallowed because of passive loss limits, that portion exceeding the passive loss limit is carried forward, aggregated and may be deducted in the year of disposal (sale). For example, you earn $130,000 in household income. Your passive loss is limited to $15,000. If your rental loses $25,000, only $15,000 can be deducted this year while $10,000 is carried forward as a disallowed loss. When you sell your property all your disallowed losses are then deducted to reach your ultimate capital gain or loss on the sale.
There is another angle to all this- if you are a real estate professional (materially participate more than 50% of your time and 750 hours per year managing each rental activity), you can claim 100% of your losses and you are not capped by passive loss limits. This makes sense since your rental income is no longer passive if it is your livelihood or a strong portion of your livelihood. Regardless of meeting the IRS definition, if you hire a management company you are climbing a steep mountain to be considered a real estate professional.
The rules for material participation as real estate professionals are considerably stringent, and are discussed in our Real Estate Professional and Material Participation tax article at-
So, are rental properties good tax shelters? Perhaps, depending on your situation. Are they good investments? Typically Yes- at some point the rental will cashflow (if it doesn’t already) and it will also appreciate in value.
The tax shelter question also hinges on your future tax rate, and how recaptured depreciation can be affected. Please see Is depreciating my rental a good thing? (part 3 of 3) regarding rental properties, depreciation and future income tax rate.