The IRS imposes various rules that determine whether you can claim a deduction for rental expenses when you have no rental income, or when the expenses exceed your rental income. Before you claim expenses under either scenario, ensure that at-risk and passive activity rules don't limit the detectability of your expenses.
At-Risk Deduction Limits
The first limitation on rental expenses to consider are the at-risk rules. Essentially, the IRS allows deductions for expenses that exceed your rental income to the extent you are at-risk for the amount. Taxpayers are at risk only for amounts that they have invested in the property. To illustrate, suppose you find a great deal on a beachfront condominium for $15,000 and your goal is to rent it to tenants. At the end of the year, you are only at risk for $15,000. This means if you don’t earn rental income, the maximum deduction you can claim is $15,000, the amount you are at risk for.
Passive Activity Limitations
Unless you actively engage in rental activities, the IRS considers rental real estate a passive activity. When you calculate your income tax at the end of the year, you must separate your passive activities from your non-passive activities, such as employment income. The significance of this allocation is that you can deduct only expenses for passive activities against income from passive activities. Therefore, if you have no other passive income, you cannot deduct your rental expenses without any rental income. For example, suppose you have two rental properties with total rental income of $15,000 and combined expenses of $20,000. In this scenario, $5,000 is not deductible since you have insufficient passive income to deduct it from.
Active Participation Exception
If you actively participate in managing your rental properties, the IRS provides an exception to the limitation on passive deductions. The IRS exception allows a deduction for rental expenses and losses that exceed the rental income, up to $25,000. However, active participation requires that your rental properties require a significant amount of your time to make management decisions, screen prospective tenants or provide services to tenants, such as daily linen and cleaning services.
There are some limits to the exception for your active participation in rental activities. The full $25,000 deduction is available only to single and married taxpayers who file joint returns. If you are married filing separately, the maximum annual deduction is $12,500 rather than $25,000. For taxpayers who have a Modified Adjusted Gross Income (MAGI) in excess of $100,000 but less than $150,000, the maximum deduction is cut by half. And if your MAGI is $150,000 or more, you cannot deduct any excess rental expenses regardless of active participation. Your MAGI is the same as the AGI you calculate on your return but without including the taxable portions of your Social Security income and the deduction for your IRA contributions, as well as other specific tax items.