Many landlords hear that being “active” in rental real estate unlocks tax benefits. That’s partly true. However, the rules use two different terms, active participation and material participation, and they mean different things. This guide explains how active rental real estate is taxed and which benefits you can actually claim.
Rental real estate starts out passive
Under the tax code, rental real estate is generally a passive activity, no matter how many hours you work on it. So rental losses can usually offset only passive income. Unused losses carry forward until you have passive income or sell the property.
However, three main exceptions can let you use losses sooner.
Exception 1: Active participation and the $25,000 allowance
If you “actively participate,” you may deduct up to $25,000 of rental losses against wages and other income. Active participation is a low bar. For example, approving tenants, setting rents and approving major repairs usually counts. You must also own at least 10% of the property.
However, the allowance phases out as your modified adjusted gross income rises from $100,000 to $150,000. Above $150,000, it disappears.
Exception 2: Real estate professional status
If you qualify as a real estate professional, your rentals aren’t automatically passive. To qualify, you must spend more than 750 hours and more than half of your working time in real property businesses where you materially participate. In addition, you must materially participate in the rentals themselves. Then your rental losses can offset other income.
How material participation works
Material participation is a much higher bar than active participation. The IRS has seven tests. For example, you qualify if you work more than 500 hours on the activity. Alternatively, you qualify if you work more than 100 hours and more than anyone else, including property managers.
Exception 3: Short-term rentals
If the average guest stay is seven days or less, the property generally isn’t a “rental activity.” So if you materially participate, your losses may be non-passive, even without real estate professional status. See our guide to short-term rentals under 7 days.
Self-employment tax and reporting
Rental income is generally reported on Schedule E and isn’t subject to self-employment tax. However, if you provide substantial services, such as daily cleaning or meals during stays, the activity may be a business reported on Schedule C. In that case, self-employment tax applies.
Document your hours
The IRS closely reviews claims of material participation and professional status. So keep a detailed, contemporaneous log of your hours and tasks. For the official rules, see IRS Publication 925, Passive Activity and At-Risk Rules.
Get help with active rental real estate
We help landlords understand which exception fits and document it properly. To discuss your rentals, call (415) 842-2940 or book a free 15-minute call.