Passive Activity Loss

A passive activity loss is the amount by which your deductible rental expenses exceed your rental income for the year, which the IRS treats as a loss from a passive activity. Under the passive activity rules, you generally cannot deduct that loss against your wages or other non-passive income; you can only offset it against income from other passive activities, with one big exception for landlords who earn under a certain amount and actively participate.

In practice

Say you own a duplex you rent for $2,400 a month, so $28,800 of rent for the year. Your deductible expenses run $9,000 for mortgage interest, $4,200 for property tax, $1,800 for insurance, $3,000 for repairs, $2,200 for management and other operating costs, and $9,800 of depreciation. Add those up and you have $30,000 of deductions against $28,800 of rent, which produces a $1,200 passive activity loss. Notice that depreciation, a paper expense with no cash leaving your account, is what tipped the year into a loss.

Whether you can use that $1,200 this year depends on your income. If your modified adjusted gross income is $100,000 or less and you actively participate in the rental (you approve tenants, set rent, and arrange repairs), the special $25,000 allowance lets you deduct the loss against ordinary income. The allowance phases out by 50 cents for every dollar of MAGI over $100,000 and disappears entirely at $150,000. So a landlord at $130,000 MAGI is $30,000 over the line, loses $15,000 of the allowance, and keeps $10,000 of room, which still easily covers the $1,200.

Why it matters to a small landlord

The passive activity rules decide whether a paper loss saves you money now or sits on the shelf. If your income is over $150,000 and you are not a real estate professional, that $1,200 does not vanish; it becomes a suspended carryforward that follows the property until you have passive income to absorb it or you sell. The two levers most likely to create a loss in the first place are depreciation and how you classify spending, which is why it pays to get your depreciation schedule right and to map every expense to the correct Schedule E line before you hand the year to your CPA.

The figures here are the ones in effect as I write, but the $25,000 allowance and the $100,000 to $150,000 phaseout are IRS specifics that can change, so confirm the current numbers for your filing year.

Passive activity loss sits next to a handful of other terms worth knowing. The bonus depreciation rules can swing a property into a large first-year loss, the QBI deduction works on the net income left after these limits, and any suspended losses you have been carrying finally free up against capital gains in the year you sell.