New Tax Law Affects Rental Losses
QUESTION: Since there are hundreds of thousands of Americans who own and rent out vacation homes, I am quite surprised that I haven’t seen in your column a question about the taxation of rental property under tax reform. As I understand the revisions, rental property will from now on be considered passive income under certain circumstances and will be treated differently than it is now. Previously, losses from a resort condominium rental, for example, could be used to offset ordinary income. Now, I understand, losses from such business property can only be deducted if the taxpayer has passive income in an equal or greater amount. Would you please clarify this?--E. J. T.
ANSWER: The short answer is that your understandings are correct.
For many years, property owners who rented out their property could subtract from their salary or any other so-called earned income any losses they had in connection with that investment. That was a big tax break because it enabled them to reduce their taxable income and, thus, their tax bill.
Beginning next year, however, they generally can deduct such losses only if they also report a very specific type of income--passive income. Having a salary in an amount equaling or exceeding the investment losses will no longer be good enough.
What is passive income? Even that changes beginning next year. Currently, passive income is basically anything other than direct compensation for your services. Hence, interest on your savings and investments is categorized as passive income. So is income from limited partnerships and rental properties. And so are dividends, royalties and capital gains.
As of next year, though, interest earnings, dividends, royalties and the like will be classified not as passive income but as portfolio income. What that means is that if your only income is from salaries and portfolio income, you won’t be able to deduct your real estate rental property losses. To deduct them, you must have passive income. (For the one exception to this rule, keep reading.)
Generally speaking, tax reform defines passive income as earnings from an investment activity in which the taxpayer doesn’t “materially participate.”
If you are a limited partner in a limited partnership investment, for example, you are forbidden by law from materially participating in the management of the investment. So, limited partnership income is regarded as passive under tax reform.
Conversely, if the investment activity in question is your principal business, you can assume that you are materially participating in it.
But other types of investments won’t be as easy to figure out--least of all, real estate rentals.
Accountants who have analyzed the tax law revisions say investors generally will have to decide whether they are involved in the operations of the investment activity on a “regular, continuous and substantial basis.” That is true regardless of whether the investment is organized as a sole proprietorship, a general partnership or a Subchapter S corporation (small corporations that are allowed to distribute income directly to shareholders).
But none of that matters for real estate rental income. Rental income, from next year on, will be classified as passive--regardless of whether the recipient materially participates in its management.
But don’t jump to conclusions. This change doesn’t necessarily mean that your losses from such rental investments can only be deducted if you have passive income. The lawmakers didn’t make it that easy.
The one exception to the new law on rental activities is a significant one--and one that is causing great confusion among real estate owners who rent out their property. In a concession to middle-income taxpayers, the new law permits individuals with annual incomes of less than $150,000 to offset part of their non-passive income with losses and credits from rental real estate activities if they “actively participate” in the investment.
As Price Waterhouse tax partner Gayford Hinton explains it, rental property owners can qualify for this exemption if they have at least a 10% ownership interest in the property and if they participate in the management decisions of that property. If you approve the new tenants and sign off on repair bills, for example, you probably will qualify. But if you assign an agent to do such things, Hinton says, you probably won’t qualify. And if you are a limited partner in such a rental deal, you definitely won’t qualify.
Once you establish that you do indeed actively participate in your real estate rental investment--and that you are entitled, therefore, to deduct any losses even if you don’t have offsetting passive income--then you determine your adjusted gross income. If it is $100,000 or less, you can offset up to $25,000 of your non-passive income with your losses from passive activities. You lose 50 cents of that $25,000 allowance for every $1 by which your income exceeds $100,000. That means that if your adjusted gross income is $150,000 or more, you don’t qualify for the allowance.
Those whose passive investment losses are disallowed will be entitled to carry forward these unused losses to future tax years. And once the taxpayer disposes of his entire interest in the investment activity, his unused losses will be allowed in full--regardless of whether he has enough passive income to offset them.
The new rules generally apply in full from next year on. But again, there is an exception. The rules will be phased in over five years for investors with losses in passive investments made before Oct. 22--the day the law was enacted. That means 35% of the losses will be disallowed in 1987, 60% in 1988, 80% in 1989, 90% in 1990 and 100% thereafter.
