Passive activity loss rules: whether you can actually use the deduction

The default

Rental activity is passive by default under section 469, regardless of how much work you do. Passive losses offset passive income. They do not offset wages, business income you materially participate in, portfolio income or capital gains.

An accelerated loss from a cost segregation study on a rental is therefore, by default, useful only against other passive income.

What happens to the excess

It suspends. Suspended losses carry forward indefinitely and attach to the activity that generated them. They release in two circumstances: when the activity generates passive income in a later year, or when you dispose of your entire interest in the activity in a fully taxable transaction to an unrelated party.

So the deduction is not lost. But a deduction you cannot use for eight years has a present value materially below its face amount, and any honest feasibility analysis says so.

Route one: real estate professional status

Under section 469(c)(7), if you spend more than 750 hours during the year in real property trades or businesses in which you materially participate, and more than half of your total personal service time is in those activities, your rental activities are no longer automatically passive.

You then still have to materially participate in each rental activity — or make a grouping election under Reg. §1.469-9(g) to treat all interests in rental real estate as a single activity, which makes the participation test far easier to meet.

The 750-hour and more-than-half tests are personal, not per-spouse-combined for the hours themselves, though a spouse's participation counts for material participation. Someone with a full-time non-real-estate job almost never qualifies.

Route two: the short-term rental position

An activity is not a rental activity if the average period of customer use is seven days or less. That removes the automatic passive classification without needing REP status — but material participation is still required.

This is the route most commonly used and most commonly overstated. See our short-term rental article for the detail.

Route three: have passive income

The simplest and least discussed. If you own other rentals producing income, or an interest in a business in which you do not materially participate, an accelerated loss shelters that income immediately.

Investors with a portfolio frequently find that a study on one property usefully offsets income from three others.

Also check section 461(l)

Even a non-passive loss can be limited. The excess business loss rules cap the amount of net business loss an individual can use against non-business income in a year, with the excess becoming a net operating loss carryforward. On a very large first-year deduction this bites.