How losses are classified can have significant tax consequences. For real estate investors, knowing when and how they can use losses to offset income can have major implications for their taxes.

Whether income is considered passive or nonpassive is a key part of taking a deduction for a loss. Passive income is from sources in which the taxpayer did not materially participate (e.g., interest from a high-yield savings account). Nonpassive, or active, income is what taxpayers earn from employment.

The general rule is that losses from passive income cannot offset nonpassive income. Any net losses from passive activity can only offset income derived from other passive activity.

The IRS classifies rental income as a passive activity. This means that, for example, a taxpayer can potentially deduct losses from one rental property from income gained from another rental property.

What About Material Participation?

The IRS states that an activity isn't classified as passive if a taxpayer materially participated in the activity. The IRS has seven tests to determine material participation, including the number of hours that a taxpayer dedicates to that activity in a year. With a few exceptions, these rules don't apply to real estate investors.

The IRS classifies income derived from real estate as passive, regardless of how much time an investor has dedicated to the income stream. The IRS does, however, allow taxpayers to carry forward a loss to future tax years.

In addition, one exception to the above is that real estate investors can deduct up to $25,000 of rental losses against nonpassive income. To qualify, a taxpayer must be able to show they owned at least 10 percent of the property and actively participated in managing their rental properties.

The $25,000 allowance has phase-out rules if a taxpayer's modified gross adjusted income (MAGI) exceeds certain amounts. For example, anyone whose MAGI is more than $150,000 cannot use the allowance.

What if a Taxpayer is a Real Estate Professional?

Taxpayers who meet the IRS's definition of a real estate professional can claim losses as nonpassive income.

The two general rules for qualifying as a real estate professional are:

• At least half of the personal services a taxpayer performed during the tax year were in real property trades or businesses in which they materially participated.
• They performed or worked at least 750 hours in real property trades or businesses in which they materially participated.

If you're a real estate investor who has questions about your potential tax liability, including how to calculate losses, call Senior Partner, Tax Controversy Attorney, and former IRS attorney Brandon A. Keim at (602) 200-7399 or contact him online to discuss your options.