Can High-Income Earners Deduct Rental Losses on Their Taxes?

January, 24 2025 by Carolyn Richardson, EA, MBA

If you’re finally getting ahead in the world and find yourself with some extra cash every month after taking care of your basic needs and having some fun, you may be thinking of investing that money in something other than retirement accounts, particularly if you’ve already maxed out on your retirement contributions for the year. Maybe you came into an inheritance and are wondering what to do with that money. And maybe – just maybe – you’re living in a part of the country where real estate prices aren’t insane. Even if they are insane, you may be looking at how quickly real estate can appreciate and think owning another property might be a better investment than the stock market. And with that in mind, you might be thinking of buying a rental property. Or perhaps you might be thinking of sizing up your current residence – or sizing down – and don’t need to sell that property to buy another one. Should you buy a residential rental property? We’re going to focus this blog on residential rentals rather than commercial ones, as there are special tax rules that apply to residential rental property, as we’ll discuss below.

The decision to buy another property can be complicated and should not be contemplated without the advice of a competent financial advisor. And there are some tax complications that might arise that you may not be aware of, particularly if your income is fairly high. You may be contemplating a potential tax write-off on the property to help save you on income taxes, for example. And, in today's real estate market, you generally need to have a good income to even qualify for a mortgage on the purchase of a rental property if you don’t have enough cash to purchase a property outright.

To start, rental activities are considered to be “passive” activities under the tax code. Under the passive activity rules, losses and expenses attributable to passive activities may be deducted only from income attributable to passive activities. The effect of this treatment is to prohibit the use of passive losses to offset "nonpassive" income, such as compensation for services, portfolio income (interest, dividends, royalties, and gain from the sale of property held for investment), and income from a trade or business in which the taxpayer materially participates. Similarly, tax credits attributable to passive activities may be used only to offset taxes attributable to income from passive activities.

However, for the owners of rental real property, there is a special provision in the tax code that allows you to claim up to $25,000 in losses annually if you “actively participate” in the management of the property. Active participation relates only to rental real estate activities. Active participation standards are met if the taxpayer (or spouse) participates in the management of the rental property in a significant and bona fide sense. In other words, this means the taxpayer's participation in the real estate activity must be regular, continuous, and substantial. Examples of activities that demonstrate active participation include approving new tenants, deciding on rental terms, and approving capital or revenue expenditures. It does not include reviewing financial statements related to the property or travel time to and from the property to perform maintenance or collect rent.

Only individuals can actively participate in rental real estate activities, and the taxpayer (and/or spouse) must hold at least a 10% interest in the activity throughout the year. In determining whether a taxpayer actively participates, the participation of both spouses is taken into account. If the property is held by a partnership, and the individual is a limited partner, then they cannot be an active participant even if the ownership interest is 10% or greater. There is an exception to the individual rule for a decedent’s estate, which is treated as an active participant for its tax years ending less than two years after the decedent’s death if the decedent would have satisfied the active participation rule in the year the decedent died.

There is a catch to this special allowance for losses, however. This is because the $25,000 limit is reduced by $1 for every $2 your modified adjusted gross income exceeds $100,000. So, if your modified adjusted gross income reaches $150,000, your allowable losses for active participation in a real property rental activity are reduced to $0 for the year. To make it worse, the income amounts are not indexed for inflation and have remained the same since they were originally enacted in 1987.

Do you just lose these losses and are never able to take them? No, the losses are suspended for the current tax year, and you get to carry them over to the next tax year. This reporting is done on Form 8582, Passive Activity Loss Limitations, which you attach to your tax return every year to calculate if you can claim any of the losses for the year and, if not, how much of the losses can be carried over. When your rental activity starts to turn a profit on your tax return, you can then use these suspended losses to reduce the taxable income that you would otherwise report on your return from the rental.

This might sound like a pretty raw deal – you are incurring losses on your rental property and not getting a tax deduction for them. However, it might actually work to your advantage, particularly if you decide you like investing in real estate and buy additional properties as time and money allow. Not only are you building equity in those properties by paying down a mortgage, but you’ll also get a good return on your investment from the general appreciation in the real estate market, barring calamities that might destroy or reduce the value of your property, like fires or hurricanes. You may even be scaling up your investment, going from a single-family home for rent to a multi-unit apartment building over the years. It might sound crazy, but not deducting the loss now can result in big profits later.

Let’s look at an example from an actual client return I prepared a few years ago. Anne and her husband were big into real estate, investing in multiple properties over a period of about 10 years. All of the properties were incurring losses, which they were unable to claim on their tax returns. In some cases, there were some small profit years on one property, but because of the deprecation deduction they were able to take on the properties, they were still showing losses on the return. By the time I was doing their returns, they had about $1 million in suspended losses on their rentals. In the meantime, the real estate market where they owned most of their properties showed huge returns on value, in some cases over 10% a year. Anne decided that she wanted to sell one of her larger properties, a four-unit complex, and use the funds for other things. As a result, she didn’t want to engage in a tax-free like-kind exchange, which would have required her to purchase another property. She wanted to keep the cash, but she also wanted to know how badly it would hurt her on the tax return.

Anne had an offer on the property, so she asked what it would cost her in taxes if she sold the property. Anne was going to show about a $1.2 million gain on the sale, which, if that were the end of the story, it would have cost her roughly half a million dollars in taxes. But after the selling costs and some repairs to sell the property were factored in, the rest of the gain from the sale of the property was tax-free – the suspended losses on her other properties could be used to offset the gain on this particular property that year because it was all considered to be passive income, and passive gains can offset suspended passive losses. The cost of selling the one property was $0 in taxes!

This is why suspending the losses on a property can work to your advantage on your taxes, although you may need to exercise some patience. And you don’t have to have other properties with suspended losses to enjoy this kind of tax deferral on the sale of a property. Even if you have one property and are suspending the operating losses on it, if you later sell the property, the suspended losses are no longer suspended, and the losses can be used. As a result, if you sell it at a gain, the sale may have a considerably smaller tax impact than you think because the gain can be reduced by the previous losses. Or, if you sell the property at a loss, the suspended losses are treated as ordinary losses and can offset other income, including depreciation recapture, and potentially create a net operating loss that can be carried over to the following year.

In conclusion, sometimes you need to play the long game when it comes to your taxes and investments. Buying real property can add a nice investment to your portfolio and provide years of income when you are retired, as well as the benefits of appreciation. So, just looking at “Can I deduct it this year?” may not be the optimal way of looking at rental property investment. As always, when it comes to investing, you may want to talk to your financial planner and your tax adviser before making any broad moves with your money.