Case study: maximizing the use of the special $25,000 rental real estate loss allowance.

• Author: Ellentuck, Albert B.

EVEN THOUGH RENTAL INCOME OR LOSS is generally passive, a special rule allows qualifying individuals and estates to offset up to $25,000 of nonpassive income with rental real estate losses and credits. To qualify for the $25,000 deduction, the taxpayer must own at least 10% of the value of all interests in the activity at all times during the tax year and must actively participate in the operations of the rental property in both the year the loss is incurred and the year recognition is sought, if different (under the carryover provisions).

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Ownership and Active Participation

A taxpayer will not be considered an active participant in a rental real estate activity if, at any time during the tax year, his or her ownership in the activity drops below 10% of the value of all interests in the activity (Sec. 469(i)(6)(A)). When measuring an individual's ownership in a rental real estate activity, any spousal interest is also included.

Active participation is a less stringent standard than material participation and does not require regular, continuous, and substantial involvement in the operations. Rather, the taxpayer must participate in a significant way, such as making management decisions or arranging for others to provide services (S. Rep't No. 313, 99th Cong., 2d Sess. 737, 1986-3 C.B. 737). Management activity that qualifies under the active participation test would include approving new tenants, setting rental policies and terms, and approving capital expenditures or repairs (Madler, T.C. Memo. 1998-112).

Example 1: F lives in Texas but owns 100% of a rental property in Arkansas. He receives all rent through the mail and has not been to Arkansas to see the rental property for more than a year. If problems with the property occur or repairs are needed, he hires someone in Arkansas to perform the work. F continues to set the policy on rentals and approves tenants when vacancies occur. Because F owns at least 10% of the real estate rental activity, makes all management decisions, and provides for others to perform services for the property in his absence, he actively participates even though he does not visit the property.

Example 2: F and his cousin, D, are equal shareholders in an S corporation that owns an apartment building in Las Vegas. D lives in Las Vegas, while F lives in Dallas. D makes all management decisions about the rental property. She inspects it on a regular basis and collects all rents. F has had no...