A residential rental property can produce a tax loss even when rent covers its cash expenses. Depreciation and deductible operating expenses can cause expenses to exceed rental income. Whether that loss reduces your other taxable income depends on the passive activity rules.
What is a Passive Loss?
Passive losses are losses from activities in which the taxpayer generally does not materially participate, as well as most rental activities. Common examples include:
- Rental real estate: A rental house generates $24,000 in rent but has $32,000 in deductible expenses, including depreciation. The $8,000 loss is generally passive—even if the owner manages the property.
- Limited partnership investments: A taxpayer invests in a partnership that operates a business but does not participate in its operations. A loss allocated to the investor is generally passive.
- An LLC or S corporation business without material participation: A taxpayer owns part of a restaurant but is not meaningfully involved in running it. The taxpayer’s share of the business loss may be passive.
- Equipment rentals: A taxpayer rents equipment to others. Losses from that rental activity are generally passive, subject to exceptions.
Passive losses generally offset passive income, rather than wages, interest, dividends, or income from a business in which the taxpayer materially participates. Disallowed losses generally carry forward.
For rental real estate, the special allowance may permit up to $25,000 of losses against non-passive income when the taxpayer actively participates, subject to income and filing-status limitations. Higher income can reduce or eliminate that allowance. The unused loss generally carries forward—it does not disappear.
As a side note, qualifying real estate professionals who materially participate in their rental activities may instead have non-passive rental losses.
A loss from selling stocks or mutual funds is a capital loss, rather than a passive activity loss.
Who qualifies for the allowance?
Rental real estate is generally a passive activity. Ordinarily, passive losses offset passive income rather than wages or portfolio income, such as interest and dividends.
The special allowance applies to owners who actively participate. What does it mean to actively participate? Making meaningful management decisions—approving tenants, setting rental terms, or authorizing repairs—can satisfy this requirement even when a property manager handles daily operations. Your ownership interest, including your spouse’s interest, generally must be at least 10% throughout the year.
The $25,000 allowance is an annual combined limit for qualifying rental activities, not a separate allowance for each property.
How income reduces the deduction
The income test uses modified adjusted gross income (MAGI), which can differ from the AGI shown on your return. For example, this calculation excludes passive rental losses and adds back certain deductions. You cannot simply subtract the rental loss to get below the income threshold.
Two items added back to AGI to arrive at MAGI are the deduction for a traditional IRA contribution and the deduction for ½ of the self-employment tax. Several other adjustments must be considered.
For taxpayers eligible for the full $25,000 allowance, the allowance decreases by $1 for every $2 of MAGI above $100,000:
| Modified AGI | Maximum special allowance |
| $100,000 or less | $25,000 |
| $110,000 | $20,000 |
| $120,000 | $15,000 |
| $130,000 | $10,000 |
| $140,000 | $5,000 |
| $150,000 or more | $0 |
These amounts are ceilings; the deduction also depends on your available qualifying losses.
Married taxpayers filing separately who lived apart all year have a maximum $12,500 allowance, phased out between $50,000 and $75,000 of MAGI. Those filing separately who lived with their spouse at any time during the year receive no special allowance.
What happens to the unused loss?
A loss disallowed under the passive activity rules becomes a suspended passive activity loss. It carries into the next year and is considered with that year’s income and losses.
High MAGI limits the current deduction, not the amount that can carry forward. If none of a $30,000 loss is deductible, the entire $30,000 generally carries forward. If $10,000 is deductible, the remaining $20,000 carries forward.
The carryover does not automatically become deductible next year. The rules apply again, and any unused balance continues forward without a fixed expiration period.
A three-year example
Assume an owner actively participates each year, has no other passive income, and meets all other deduction requirements.
| Year | MAGI | Prior carryover | New rental loss | Deductible loss | Carryover to next year |
| 1 | $120,000 | $0 | $30,000 | $15,000 | $15,000 |
| 2 | $160,000 | $15,000 | $10,000 | $0 | $25,000 |
| 3 | $90,000 | $25,000 | $8,000 | $25,000 | $8,000 |
In Year 1, income reduces the allowance to $15,000. Half the loss is deductible and half carries forward.
In Year 2, income eliminates the allowance. The old $15,000 and new $10,000 loss produce a $25,000 carryover.
In Year 3, the full allowance is available. The owner has $33,000 in combined losses, deducts $25,000, and carries $8,000 into Year 4. Prior losses and current losses share the annual allowance; each does not receive its own $25,000 limit.
Can the losses be used while income remains high?
Yes. The MAGI phaseout restricts the special allowance against non-passive income. Suspended losses may still offset qualifying passive income.
For example, an owner with $180,000 of MAGI, a $25,000 suspended loss, and $6,000 of passive rental profit may generally use $6,000 of the carryover against that profit. Assuming no other relevant income or losses, $19,000 remains suspended.
Another opportunity arises when the owner sells the entire interest in the rental activity to an unrelated buyer in a fully taxable transaction. Remaining suspended losses generally become deductible under the disposition rules, even when income exceeds the phaseout threshold. Grouped activities, installment sales, and other special circumstances require separate analysis.
Keep the carryover records
Form 8582 and its supporting schedules generally determine deductible passive losses and track suspended amounts by activity. Keep those records with your depreciation schedules, particularly when changing preparers.
This discussion concerns federal passive activity limits. Basis, at-risk, personal-use, and other rules can also limit deductions. Qualifying real estate professionals who materially participate may fall under different rules.
For a rental owner, an unused loss can represent a future tax benefit. Accurate carryover records help preserve that benefit until income, rental profits, or a qualifying sale permits its use.