Common errors in rental loss reporting
Generally, Schedule E rental losses are considered passive activity losses. These losses are deductible only against income from passive activities. Nondeductible passive activity losses (losses that exceed the income from the passive activity) for the year are "suspended passive activity losses." Suspended losses can be carried forward indefinitely and used in subsequent years against passive activity income. They are allowed in full upon a taxable disposition of the activity, i.e., when the property is sold.
Although the general rule seems straightforward, federal and state differences, along with special rules, can create opportunities for errors. The following are three common errors related to the Schedule E, page 1, pertaining to rental real estate losses found on both self-prepared and tax practitioner-prepared returns.
- Passive vs. non-passive for rental real estate activities
For both Federal and California tax returns, a passive activity includes any trade or business in which the taxpayer does not materially participate, and any rental activity regardless of participation. Beginning in 1994, and for federal purposes only, rental real estate activities performed by qualified real estate professionals are not automatically treated as passive activities. California does not conform to this provision. Therefore, for California purposes all rental activities are considered passive activities.
- Special allowance for passive real estate rental activities
California conforms to the Federal special allowance rules for those taxpayers who actively participate in rental real estate activities. Under this rule, up to $25,000 of passive rental real estate losses may be used to offset non-passive income. This $25,000 limitation is reduced when an individual's modified adjusted gross income (MAGI) is more than $100,000. Once MAGI exceed $150,000, the $25,000 is reduced to zero. Refer to Federal form 8582 and California form 3801 for instructions on how to correctly calculate the limitation phase-out and allowable loss.
- 1031 Exchanges and suspended passive losses
For both Federal and California purposes, current and suspended passive losses are fully deductible on the disposition of a passive activity; when a taxpayer sells his or her entire interest in a rental property, for instance. However, three criteria must be met before losses are deductible against non-passive income:
- It requires that the taxpayer dispose of an entire interest in a fully taxable transaction to an unrelated party.
- All gain realized must be recognized.
- Therefore, in an exchange of the taxpayer's interest, such as a 1031 exchange in which no gain or loss is recognized, suspended passive losses are not deductible.
For more information on how to correctly calculate and report rental real estate deductions, consult:
- California R&TC Section 17561
- Internal Revenue Code Section 469
- IRS Publication 925