The Passive Activity Loss Rules and Cost Segregation

If there is one set of rules that decides whether a cost segregation study pays off for an individual owner, it is the passive activity loss rules. They are found in Section 469 of the tax code, and they limit when losses from certain activities can offset other income. This page gives an overview. It is a simplification, and the rules have exceptions and details that matter.

The basic rule

Losses from passive activities generally can be deducted only against income from passive activities. If your passive losses exceed passive income in a year, the excess is suspended and carried forward. Passive activities generally include trade or business activities in which you do not materially participate, and, with exceptions, rental activities regardless of participation.

Why rentals are special

Rental activities are treated as passive by default even if you work hard at managing them. That means an ordinary landlord's rental losses are subject to the passive limits. The tax code then provides exceptions.

Exception 1: the small-landlord allowance

A limited allowance, in general terms, lets an individual who actively participates in rental real estate deduct a portion of rental losses against other income, up to a statutory dollar amount. Active participation is a lower standard than material participation and can be satisfied by, for example, approving tenants and setting rents. The allowance phases out as modified adjusted gross income rises above a threshold and is unavailable above a higher threshold. The amounts are set by statute and are not adjusted for inflation as generally understood, but verify. See Tax Bracket and Whether Deductions Are Usable.

Exception 2: real estate professionals

An individual who meets the requirements for real estate professional status and materially participates in a rental activity may treat it as nonpassive. See Real Estate Professional Status and Study Decisions.

Exception 3: activities that are not rentals

The definition of a rental activity excludes certain arrangements, including activities where the average customer use period is short, such as many short-term rentals, when other conditions are met. If not a rental activity, the activity is classified by whether you materially participate. See The Short-Term Rental Rules Explained Carefully.

Exception 4: disposition

When you dispose of your entire interest in a passive activity in a fully taxable transaction to an unrelated party, suspended losses from that activity generally become deductible. See Suspended Losses and Carryforwards.

Passive income can absorb passive losses

If you have passive income from other sources, such as other profitable rentals or partnership interests, your passive losses can offset it. An owner with a portfolio may find that a loss from one property is absorbed by income from another.

What this means for a study

A study accelerates deductions, which increases losses in the early years. If those losses are passive and you have no passive income, they are suspended. Suspended losses are not lost, but they do not reduce your current tax. That is why the first question in a study decision is whether the deductions will be usable. See Cost Segregation Decision Checklist.

Grouping

You may be able to group certain activities in ways that affect participation tests and passive income calculations. Grouping rules are technical and, once chosen, generally must be followed consistently.

Other limits also apply

Even if the passive rules are satisfied, other limits, such as at-risk and excess business loss rules, can restrict losses. See At-Risk and Excess Business Loss Limits.

Common misunderstandings

• "I manage my own properties, so I am not passive." Not necessarily for rentals.
• "A study creates a loss I can use against my salary." Only if you satisfy an exception.
• "Suspended losses disappear." They generally carry forward.

A hypothetical

See Hypothetical: Passive Limits and Suspended Losses.

Illustrative owners in words

An employee with a rental house and no other real estate has passive rental losses limited by the passive rules unless the small-landlord allowance applies. An owner with three rentals, two profitable and one new with a study, can net the losses against the profitable properties' income. A physician who invests in a real estate partnership as a limited partner has passive income or loss from the partnership. A full-time property manager who owns rentals may qualify for real estate professional status. Each faces different results from the same rules.

Recordkeeping for the passive rules

Passive activity computations require tracking income and losses by activity. Keep prior year forms and the schedules that show carryforwards. When you change preparers, provide the carryforward information, since errors in carryforwards are common. When you sell, your preparer will use the records to release losses properly.

Planning questions

Do I expect passive income in the coming years? Could I restructure my activities to include more? Would a change in my work life make sense in its own right and also affect the classification? Would I be comfortable if a status claim were reviewed? These questions belong in a conversation with your advisor, not a solo decision.

A reminder on the moving parts

Rules include thresholds and definitions that change. Verify current amounts with your preparer, including the small-landlord allowance and its phaseout, before relying on any figure.

Next steps

Read Material Participation Tests in Plain Language to see how hours and roles are measured.