Understanding Passive Activity Rules for Real Estate Investors

zlkcpa
Oct 7
3 min read

If you own rental property or are thinking about investing in real estate, it’s important to understand how your income and losses are treated for tax purposes. The IRS has specific rules that determine whether your real estate activity is passive or active, and those classifications directly affect what you can deduct each year.

What Is Passive Activity?

In the simplest terms, a passive activity is something you invest in but don’t personally manage on a regular basis. The IRS generally classifies rental real estate as passive, even if you make management decisions or check on the property.

Here’s why that matters:

Passive income includes money earned from activities you don’t actively run day-to-day, such as rental income or limited partnerships.
Passive losses (like property depreciation, repairs, or other expenses) can only be used to offset passive income, not your wages, business profits, or other active earnings.

That means if you have rental losses but no other passive income, those losses might not reduce your tax bill right away. Instead, they’re carried forward to future years until you have passive income to use them against or you sell the property.

The $25,000 Special Allowance for Active Participation

There’s a valuable exception designed to help smaller investors. If you actively participate in your rental activities, meaning you make key decisions like approving tenants, setting rental terms, or authorizing repairs, you may qualify to deduct up to $25,000 of passive losses against your non-passive income.

However, this benefit is phased out based on income:

If your modified adjusted gross income (MAGI) is between $100,000 and $150,000, the deduction gradually decreases.
Once your income exceeds $150,000, you can’t use this special allowance.

This rule often helps part-time landlords who are involved in managing their properties but don’t meet the stricter “real estate professional” definition.

Real Estate Professionals: A Different Category

If real estate is your full-time business, you may be able to treat your rental activities as non-passive and fully deduct losses. To qualify as a real estate professional, you must meet both of these requirements:

You spend more than 750 hours per year working in real estate activities (such as development, construction, brokerage, or management).
More than half of your total working hours are devoted to those real estate activities.

Even then, you must show material participation - in other words, you’re involved in the operations on a regular, substantial, and continuous basis.

This distinction can make a major difference in how much tax you pay, but it also requires detailed documentation of your hours and activities.

Why These Rules Exist

The IRS created the passive activity rules to prevent taxpayers from using investment losses to offset unrelated income, like wages or business profits. While the rules can seem restrictive, they’re designed to separate “true investments” from active business operations.

Understanding where your real estate activities fit under these rules helps you make smarter tax and investment decisions—and avoid unpleasant surprises at tax time.

Key Takeaways for Real Estate Investors

Most rental activities are considered passive, even if you’re somewhat involved.
You may qualify for a $25,000 special allowance if you actively participate in your rentals and your income is under $150,000.
Real estate professionals who materially participate can treat losses as non-passive.
Good recordkeeping and participation logs are essential if you want to support your position with the IRS.

How Kamish & Associates Can Help

At Kamish & Associates, we work with real estate investors every day, helping them understand how these rules apply, identify tax-saving opportunities, and stay compliant with current IRS regulations.

If you’re not sure whether your real estate income counts as active or passive, or if you want to make sure you’re taking advantage of all available deductions, we can help you review your situation and plan ahead.

Contact Kamish & Associates today to schedule a consultation and learn how to make the most of your real estate investments.