Rental real estate is often promoted as a tax-efficient investment. Depreciation, repairs, and financing costs can easily turn a profitable property into a tax loss on paper. Yet many business owners are surprised to discover that those losses don’t actually reduce their taxes in the year they occur.
The reason is the IRS’s passive activity loss rules, which treat rental real estate differently from most other business activities. Understanding these rules — and the exceptions — can make the difference between losses that help you today and losses that sit unused for years.
This article explains how the rules work in plain English and highlights practical planning ideas business professionals should be aware of.
The IRS’s View of Rental Real Estate
Under federal tax law, most rental real estate activities are automatically classified as passive. This is true even if the owner spends significant time managing the property.
Passive losses generally cannot be used to offset:
Wages
Business income
Professional fees
Investment income such as interest or dividends
Instead, passive losses are typically suspended. They carry forward to future years and can only be used when one of two things happens:
The taxpayer has passive income from another source, or
The property is sold in a fully taxable transaction
For many investors, that means losses accumulate year after year without providing immediate tax relief.
The $25,000 Rental Loss Exception
Recognizing that many small property owners are actively involved in their rentals, Congress created a special exception. Under this rule, qualifying taxpayers may deduct up to $25,000 of rental real estate losses per year against non-passive income such as salary or business profits.
This exception can be extremely valuable, but it comes with strict requirements.
Requirement #1: Minimum Ownership
To qualify, you must own at least 10% of the rental property during the entire year. For married couples, the IRS treats both spouses as one unit, so a spouse’s ownership interest counts toward the 10% threshold.
If ownership drops below 10% at any point during the year, the deduction is lost for that year.
Requirement #2: Active Participation
Active participation is often misunderstood. It does not mean working full-time in the business or handling daily operations.
Instead, it means being involved in meaningful management decisions, such as:
Approving tenants
Setting rental terms
Deciding on repairs or improvements
Hiring or supervising property managers
You do not need to live near the property or visit it regularly. Owners who live out of state can still qualify, as long as they remain involved in decisions.
On the other hand, investors who simply provide capital and have no management involvement do not qualify. Likewise, rental real estate owned through limited partnerships is generally excluded from this exception.
Income Limits: Where Most Taxpayers Lose the Benefit
Even if you meet the ownership and participation requirements, your income level plays a major role.
The $25,000 allowance begins to phase out when income exceeds $100,000
It is completely eliminated once income reaches $150,000
The phaseout is based on modified adjusted gross income, which is not always the same as the income shown on your tax return. Certain deductions are added back, and certain types of income are treated differently, causing many taxpayers to exceed the limits sooner than expected.
For business owners whose income falls within or near this range, planning becomes critical.
Planning to Preserve the Deduction
Because the phaseout is tied to income, only strategies that reduce adjusted gross income or shift income between years can help.
Examples include:
Contributing to SEP or Keogh retirement plans
Timing income and expenses for cash-basis businesses
Deferring income into future years where possible
Investing in income-deferred or tax-exempt vehicles
Itemized deductions generally do not help, since they do not affect adjusted gross income.
When the $25,000 Deduction Is No Longer Available
Many business professionals earn well above the income limits, making the $25,000 exception unavailable year after year. In those cases, rental losses are usually suspended indefinitely.
However, in certain situations, how the property is owned can change the outcome.
Using a Closely Held C Corporation
While individuals are heavily restricted under the passive loss rules, closely held C corporations receive more favorable treatment. These corporations are allowed to use passive losses to offset active business income.
This creates a planning opportunity for business owners who:
Own rental property that generates ongoing losses, and
Also own a profitable operating business structured as a C corporation
In some cases, contributing rental property interests to a closely held C corporation allows losses to be used currently rather than suspended.
That said, this approach is not without drawbacks. C corporations come with:
Corporate income tax
Potential double taxation on distributions
More complex exit planning when assets are sold
Because of these trade-offs, this strategy must be evaluated carefully and tailored to the taxpayer’s long-term goals.
The Bigger Picture
Rental real estate can be a powerful wealth-building tool, but its tax benefits are often misunderstood. Losses that look valuable on paper may not provide immediate tax savings unless the rules are navigated carefully.
Key takeaways:
Rental losses are passive by default
The $25,000 exception can unlock real savings for qualifying taxpayers
Income levels often determine whether the benefit survives
Ownership structure can dramatically affect results
For business professionals with rental properties, understanding these rules — and planning ahead — can prevent years of unused losses and unlock tax benefits that might otherwise go overlooked.