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The Small Landlord Exception and the $25,000 Special Allowance

Generally, a trade or business activity is considered a passive activity if the taxpayer does not materially participate in the activity. This means, passive activity losses may only be deducted from passive activity income and not from nonpassive activity sources of income, such as wages.

Since rental real estate activities are considered passive activities, even if the taxpayer does materially participate in the activity (except for real estate professionals), losses from such activities are normally not deductible against nonpassive income.

But, there is an exception for small landlords with modified adjusted gross income (MAGI ) under $150,000 ($75,000 if married filing separately) that allows rental losses to be deducted from nonpassive sources of income.

Modified adjusted gross income is simply the exclusion of certain items that were included in your adjusted gross income. (See "Finding Your Modified AGI" below.)

Special $25,000 Allowance for Real Estate Nonprofessionals

If you're not a real estate professional a special rule let's you classify up to $25,000 of rental losses as nonpassive. This means you can deduct up $25,000 of rental losses from your nonpassive income, such as wages, salary, dividends, and interest.

Deduction Limits

If your modified adjusted gross income (MAGI) exceeds $100,000 ($50,000 for married filing separately), the $25,000 maximum deduction amount ($12,500 if married filing separately) is reduced by 50% of each dollar over $100,000.

For example, if your MAGI is $110,000, the maximum $25,000 deduction amount is reduced by $5,000 (50% x $10,000 = $5,000) leaving $20,000 available to deduct.

If you're married and file a separte return and you did not live with your spouse at any time for entire year, your maximum deduction would be $2,500

Once MAGI reaches $150,000 the $25,000 deduction is eliminated (50% x $50,000 = $25,000).

Qualifying for the Special Allowance

To qualify for the special allowance you must (a) actively participate in the activity and (b) your interest (including your spouse's) must be at least 10% (by value) of all interests in the activity throughout the year.

Married filing separately:
The special allowance is not available if you were married, lived with your spouse at any time during the year, and are filing a separate return.

Active participation:

Active participation is not the same as material participation. Active participation is a less stringent standard and is intended to make it easier for real estate nonprofessionals to qualify for the special $25,000 rental loss deduction.

As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. For example, approvng tenants, setting the renta terms, approving maintenance and repair expenses. There is no specific hour requirement.  However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager.

You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way.

Merely signing off on what a management agent does won't cut it. Merely reviewing financial statements or conducting analysis that is unrelated to the day-to-day management or operation of the activity is not treated as participation.

You or your spouse, if married, may be treated as actively participating if you make management decisions in a significant and bona fide sense.

Using a Property Manager

Having an agent manage the property will not prevent you from meeting the active participation test. In other words, your lack of participation in operations does not prohibit qualification as an active participant so long as you are involved in a significant bona fide sense.

Finding Your Modified AGI

To figure your modified AGI , combine all the amounts on your IRS Form 1040 that you used to calculate adjusted gross income, except for the following:

  1. Taxable Social Security and tier 1 railroad retirement benefits
  2. Deductible contributions to individual retirement accounts (IRAs) and Section 501(c) (18) pension plans (trust funds by employees only formed prior to June 25, 1959)
  3. The exclusion from income of interest from qualified U.S. savings bonds used to pay qualified higher education expenses
  4. The exclusion from income of amounts received from an employer’s adoption assistance program
  5. Passive activity income or loss included on Form 8582
  6. Any rental real estate loss allowed because you materially participated in the rental activity as a real estate professional
  7. Any overall loss from a publicly traded partnership
  8. The deduction for one-half of self-employment tax
  9. The deduction for domestic production activities
  10. The deduction allowed for interest on student loans
  11. The deduction for qualified tuition and related expenses