When Are Rental Real Estate Losses Not Deductible?

Many U.S. taxpayers find themselves as landlords even while working full time in another industry. When the cost of owning a rental property starts to add up, you may wonder whether those costs can help offset your income on your U.S. tax returns. A recent case from the U.S. Tax Court provides a glimpse into when and why some rental real estate losses are not deductible.

Working Couple Maintains Rental Real Estate Properties on the Side

Robert and Pamela Drocella didn’t spend their days in the real estate business. Each had full-time jobs in other industries. Mr. Drocella worked for a defense manufacturing company, and Mrs. Drocella worked for the U.S. Department of Defense. But they also maintained six rental real estate properties in 2018. In their off hours, they renovated the properties, rented them to tenants, and handled issues that arose on the properties.

This took up a significant amount of time. Between January 14 and November 13, 2018, the couple had logged more than 1,500 hours. Mr. Drocella had spent more than 750 hours on the properties, while Mrs. Drocella worked on the properties less often.

When it came time to file their taxes, the Drocellas, filing jointly, reported a combined adjusted gross income of around $160,000. However, their tax return included a Schedule E, Supplemental Income and Loss filing, which listed nearly $63,000 in real estate loss deductions. The IRS asked for supporting documentation on the losses. When the Drocellas failed to provide it, the IRS issued a notice of deficiency in early 2021, asserting that their rental real estate losses were not deductible.

The Drocellas sued the IRS in the United States Tax Court, claiming that their rental real estate deductions were correct. The parties provided handwritten logs related to their work on the real estate properties. They also asserted that they each worked “full time” but did not provide specific numbers of hours worked in their respective careers. When the matter came before the judge, the matter boiled down to just one issue: whether the tax code’s passive loss rules allowed the Drocellas to deduct their real estate rental losses from their other income.

Passive Loss Rules Can Prevent Real Estate Losses from Being Deductible

Ordinarily, if a taxpayer is self-employed or has income from a business, they are entitled to claim business deductions for losses related to that business. This can include everything from office rental to travel expenses. However, the rules are different for “passive activities losses.” The Internal Revenue Code (IRC) prevents taxpayers from using passive losses to offset earned income. A loss is passive if the income-producing activity does not require the taxpayer to be materially involved in the activity. For example, market-related loss of value is passive because the investor who owns the shares did nothing to change its value. Passive activity losses can only be used to offset passive income.

Sometimes, real estate losses are not deductible because they are passive activity losses, and the taxpayer does not have sufficient income to offset those losses. Rental activity is considered passive unless the taxpayer claiming the losses qualifies as a real estate professional.

Who Counts as a Real Estate Professional?

Real estate professionals may deduct their rental real estate losses from their business income, just like any other business owner. However, a taxpayer only qualifies as a real estate professional under the IRC if:

(i) more than one-half of the personal services performed in trades and businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

In other words, unless the taxpayer makes owning and operating their rental property at least a part-time job, they cannot claim their rental real estate losses against the income they earn from any sources. Those losses can still be used to offset rental income, but any excess deductions are simply lost.

What it means to “materially participate” in a real estate profession is too complicated for this blog post, and was not relevant in the Drocella’s case. Instead, the Tax Court determined that neither spouse could prove that they had satisfied the working requirement to be considered real estate professionals. Because the Drocellas did not provide any information about the hours worked in their full-time employment, the Court said “petitions cannot prove that more than one-half of either petitioners’ total personal services performed in trades and businesses were performed on their rental real estate activities during that year.” In other words, while the taxpayers may have worked on their real estate business, it didn’t add up to at least half their total working hours. Because of this, their rental real estate losses weren’t deductible against the rest of their full-time income.

Claiming deductions beyond what is allowed can result in assessments, penalties, interest, and sometimes even lawsuits. The more complicated a family’s tax situation is, the more important it is to work with experienced tax preparers who understand the limits to things like passive activity losses and rental real estate deductions. That way you can claim the proper deductions the first time and avoid unnecessary litigation against the IRS.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 35 years experience. If you have questions regarding a delinquency assessment related to improper deductions, contact Joe Viola to schedule a consultation.