In Internal Revenue Service lingo, passive activity refers to business activities you didn't actively participate in. Generally, you can only use income losses from a passive activity to offset income from another passive activity, but not other income or capital gains. However, rental activity is a special case where you often can deduct some passive activity loss from other income.
If your modified adjusted gross income is $150,000 or more, or $75,000 or more if you're married and filing separately, you usually can't claim passive activity loss against other income.
What is Passive Income?
Passive income is the compensation you receive from a rental property or other business enterprise for which you're not actively involved or in which you don't materially participate. For example, if you own a stake in a partnership, a farm or another business, but don't actively work and make decisions about how the business is run, that is often classified as passive income by the IRS.
Rental Loss Limitations
Additionally, rental income, whether you're renting out a house or apartment or equipment, is generally classified as passive activity. The usual rule regarding passive activity loss is that you can only use it to decrease your tax liability from other passive income, not from your salary, your investments or other ordinary income.
There is, however, an exception if you actively participated in rental real estate activity. This can include approving tenants, signing off on repairs or capital expenditures or making decisions about rental terms for the property. In that case, you can deduct up to $25,000 in rental real estate losses from your other income.
Married Filing Jointly Loss Limits
There are, however, income restrictions that limit how much you'll actually be able to claim. Generally, if your modified adjusted gross income is $150,000 or more, you can't claim this deduction at all. If you make $100,000 or more, the deduction is limited to half the difference between $150,000 and your modified adjusted gross income.
For example, if your modified adjusted gross income is $110,000, your deduction is limited to ($150,000 - $110,000) / 2, or $20,000.
Married Filing Separately Loss Limits
The married filing separately rental loss limits are more stringent, with the cutoff set at $75,000 rather than $150,000, and the amount decreasing once your income rises above $50,000. Generally if you are married and lived with your spouse at all during the tax year, but you're filing separate returns, you can't claim the allowance at all.
Reporting Passive Activity Losses
You can carry over passive activity losses to a future tax year to offset passive activity income in the future. Use IRS Form 8582 (Passive Activity Loss Limitations) to handle reporting of a passive activity loss. Visit IRS.gov/forms and search for this form and its instructions.
Special Rules for Real Estate Professionals
Rental real estate transactions don't count as passive activity if you were a real estate professional during a tax year. That generally means, according to the IRS, that more than half the personal services you provided were real estate related and you performed more than 750 hours of services in real estate activity.