Most rental clients are not real estate professionals. For them, section 469(i) is the provision that decides whether a rental loss is deductible this year or suspended. It allows up to $25,000 of loss from rental real estate in which the individual actively participates to offset non-passive income. The allowance shrinks as adjusted gross income rises, and the dollar amounts in the statute carry no inflation adjustment.
The rule
Under section 469(i), the aggregate amount of loss from rental real estate activities that can be offset against nonpassive income is capped at $25,000 for a taxable year. The cap is reduced, but not below zero, by 50 percent of the amount by which the taxpayer's adjusted gross income exceeds $100,000. Section 469(i)(3)(E) defines adjusted gross income for this purpose as AGI figured without taxable Social Security benefits under section 86, the exclusions under sections 85(c), 135 and 137, the deductions under sections 219, 221 and 250, and any passive activity loss or loss allowed by reason of section 469(c)(7). Publication 925 lists the same adjustments, including taxable Social Security and Tier 1 railroad retirement benefits, deductible IRA contributions, passive activity income or loss on Form 8582, the deduction for the deductible part of self-employment tax and the student loan interest deduction. Use the Form 8582 worksheet rather than Form 1040 AGI.
The allowance is fully gone at $150,000 of modified AGI, because 50 percent of $50,000 is $25,000.
Active participation
Active participation is a lower bar than material participation. The taxpayer must participate in a meaningful way in management decisions, for example approving tenants, setting rental terms, approving expenditures or arranging for repairs. Publication 925 describes active participation as a less stringent standard than material participation. Publication 925 treats a manager who is an independent contractor rather than an employee as a factor against active participation, so document the owner's own approvals.
Section 469(i)(6)(A) denies active participation for any period in which the individual's interest, including a spouse's, is less than 10 percent by value of all interests in the activity. A client with a 6 percent interest in a rental partnership does not qualify, whatever her involvement. Publication 925 adds that, except as provided in regulations, limited partners are not treated as actively participating.
Married filing separately
Under section 469(i)(5), the $25,000 becomes $12,500 for a married person filing separately who lived apart from the spouse for the full year. If the person lived with the spouse at any time during the year, the allowance is zero. For a qualifying separate filer, the phase-out starts at $50,000 of modified AGI and the allowance is gone at $75,000.
Worked example
A married couple filing jointly has modified AGI of $128,000 before the rental loss. Their rental duplex produced a loss of $31,000 after depreciation. The wife approves tenants and repairs and owns 100 percent. They have no other passive income, so the whole loss runs through the allowance.
- Excess over $100,000: $128,000 minus $100,000 is $28,000.
- Reduction: 50 percent of $28,000 is $14,000.
- Allowance: $25,000 minus $14,000 is $11,000.
- Deductible loss this year: $11,000.
- Suspended loss carried forward: $31,000 minus $11,000 is $20,000.
The suspended $20,000 is not lost. Under section 469(g), if the client disposes of the entire interest in the activity in a fully taxable transaction, the loss is treated as not from a passive activity, unless the buyer is a related party under section 267(b) or 707(b)(1), in which case the release waits until the interest passes to an unrelated person. Track it by property on a carryforward schedule.
Worked example two: single filer
This follows the Publication 925 example. A single client with $120,000 of modified AGI and a $31,000 rental loss, with active participation and no real estate professional status.
- Excess over $100,000: $120,000 minus $100,000 is $20,000.
- Reduction: 50 percent of $20,000 is $10,000.
- Allowance: $25,000 minus $10,000 is $15,000.
- Deductible: $15,000. Carryforward: $31,000 minus $15,000 is $16,000.
Worked example three: separate filer who lived apart
A married client files separately and lived apart from the spouse for the entire year. Modified AGI is $60,000 and the rental loss is $20,000.
- Base allowance: $12,500, phase-out starting at $50,000.
- Reduction: 50 percent of ($60,000 minus $50,000), which is $5,000.
- Allowance: $12,500 minus $5,000 is $7,500. The client deducts $7,500 and carries forward $12,500.
If the client lived with the spouse at any point in the year, the allowance is zero and the whole $20,000 is suspended.
Common errors
- Starting the phase-out from Form 1040 AGI instead of modified AGI.
- Treating a 6 percent owner as an active participant.
- Applying the $25,000 to a limited partner interest.
- Letting a separate filer claim the allowance after living with the spouse for part of the year.
- Dropping the carryforward after a year with no allowed loss.
Questions
Does the allowance apply if the client is a real estate professional?
The allowance addresses clients who are not. A client who qualifies under section 469(c)(7) is tested for material participation instead, and the loss allowed by reason of that rule is removed from modified AGI for the phase-out.
Work the client file
- Confirm who owns each property and what percentage, by entity.
- Document active participation with emails or notes showing approvals.
- Compute modified AGI before the rental loss, then apply the phase-out.
- Maintain the carryforward schedule by activity and tie it to prior-year Form 8582.
- For clients above $150,000, evaluate whether real estate professional status is realistic, using the 750-hour test.
Sources
- Legal Information Institute, 26 U.S.C. 469, Passive activity losses and credits limited: https://www.law.cornell.edu/uscode/text/26/469
- Internal Revenue Service, Publication 925, Passive Activity and At-Risk Rules: https://www.irs.gov/publications/p925
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