Every landlord sets out to make their new rental business as profitable as possible.
But for many, success doesn’t always come within the first few years.
If you’ve recently acquired your first investment property, you probably have high hopes for your business. However, you should be prepared for the likelihood that your business operates at a net rental loss for the first few years of service.
This is because the costs to acquire, insure, and prepare a property for renters are high. Even investors with plenty of capital can struggle to profit after all property expenses are paid.
So, what should you do if your rental property business incurs a loss? How does this impact how you file your tax return?
Below are some tips and strategies for navigating rental losses come tax season.
What is a Rental Loss?
A rental loss occurs when your total expenses exceed the revenue you generate from your properties.
Rental losses are not unusual for new landlords or any kind of investor for that matter. Even after financing a mortgage, landlords are still responsible for a range of operating expenses: landlord insurance, repairs, preventative maintenance, cleaning, furnishing, rental advertising, and management fees.
Given how much it takes to purchase and place a property in service, it’s no wonder that landlords take some time to replace the lost revenue. If your profits don’t exceed the total of these operating expenses, your business has an operating loss.
Why Might You Incur a Rental Loss?
As mentioned, rental losses are common for early investors. There are several reasons why you might end up with a net loss.
A loss doesn’t necessarily mean you’re an irresponsible investor. Maybe you started your business with little capital and are counting on your investment to generate revenue over time. Or maybe you made a substantial purchase to acquire a new asset.
In these circumstances, the net loss may have been anticipated and planned.
You could be facing a rental loss because your property suffered a casualty loss, such as severe storm damage. Expensive damages may lead to a total remodeling that ends up costing more than you bargained for.
Deducting Rental Losses
When you’ve suffered a rental loss, the first thing you should do is take advantage of the IRS’s rental real estate loss allowance.
The rental real estate loss allowance is a federal tax deduction for property owners. If you have a net loss at the end of the tax year, you can deduct a certain amount of that loss from your income. However, you must adhere to certain requirements and rules, namely the passive loss and at-risk rules.
Passive Loss Rules
The Passive Loss Rules (PAL) state that you cannot deduct passive (rental) losses from your other income sources, including active or portfolio.
In other words, you cannot use your rental losses to pay less tax on your salary or other investment income. You can only deduct your rental loss from other passive income.
There are a few exceptions to the PAL rules. The $25,000 Offset exception allows small landlords to break the PAL rules and deduct up to $25,000 of rental losses from their other income. Small landlords are those whose gross adjusted income is less than $100,000. However, you still must be an active participant in your business and own at least 10% of it.
The other exception is the Real Estate Profession Exemption. According to this exemption, you can deduct any losses you want (no cap) if you are a real estate professional working actively in the industry. There are many ways to meet the requirements for this exemption—see the tax code to learn the specifics of how to qualify.
To summarize, the PAL exceptions state that if:
- Your adjusted gross income (AGI) is less than $100,000 AND
- You actively participate in your rental business (you aren’t a passive investor) OR
- You work actively in a real estate profession,
then you can use the real estate loss allowance to deduct up to $25,000 each year.
The at-risk rules are much simpler than the PAL rules. They limit your deduction amount to only the amount of money you have “at risk,” or the total amount you would lose if your business fails.
Your at-risk amount usually includes the total cash you invested up front, the adjusted basis of your property, and any loans you took out.
The at-risk rules shouldn’t affect you significantly unless you used seller financing or have an unusually favorable loan.
Operating at a net loss is anxiety-producing for any type of business owner. However, as a landlord, you have the unique opportunity to deduct these losses from your taxable income. Not only will you pay less taxes, but you’ll be better prepared to profit in the following year.