An Exception to Passive Activity Loss Rules

Dear Tax Talk,I have a rental property. I have done all the research and am now filling out Schedule E. Here are my questions.

1. What do the passive activity loss rules mean in plain English? Is it saying -- I can only deduct up to the total rents received in 2010, which is the "income of the passive activity"?

2. Exceptions for this rule: on Page E-2 I meet all the conditions except the AGI -- ($100,000 or less). And my rental expenses are already higher than the rent I received. Does this mean I cannot depreciate my rental and claim a loss on Form 1040? Do I still need to fill out Form 8582 to figure out losses?

3. If depreciation is allowed, is 4562 the form to use?

Hope to hear from you soon! I am really confused now.

Thank you.-- Mia

Dear Mia,The passive activity loss rules are nobody's PAL. The rules are very confusing for the ordinary taxpayer and hard to keep track of year to year.

Basically, a PAL is any loss coming from any rental activity such as the rental of investment property. Rental investment property is reported on Schedule E, Page 1 of Form 1040. To determine if you have a loss that may be limited, you need to compute the property's total income and expenses. Expenses always include depreciation, even if it increases an existing loss.

Depreciation is an allowance for the cost of capital used in the income-producing activity. It is not optional; you must claim it utilizing Form 4562. Residential rental property is depreciated on a straight-line basis over 27.5 years.

As you point out, an exception exists for individuals who actively manage their own rental property and have modified adjusted gross income, or MAGI, below a certain threshold. The maximum loss an individual can claim from actively managed rental activities is $25,000. The $25,000 cap is reduced by $1 for every $2 dollars that MAGI exceeds $100,000. If an individual's MAGI is $150,000, they cannot claim any passive loss.

If for example, you have $12,000 in rental income, $15,000 in rental expenses such as broker's rental commissions, condo fees, interest and taxes, and $3,000 in depreciation, your overall loss is $6,000. The $6,000 would be fully deductible if your MAGI is under $138,000. In other words, your MAGI is over the lower limit by $38,000. This excess is divided by $2 to arrive at a $19,000 reduction to the $25,000 overall loss cap, leaving up to $6,000 in deductible loss. If your MAGI is $140,000, your maximum deduction is $5,000 and the remaining excess of $1,000 is not currently deductible but rather carried forward to future years.

The $1,000 carryforward is not distinguished as any particular expense for the year. It is labeled passive activity loss carryforward and can be offset by any passive activity loss income in future years, including income from another activity. It can also be claimed as part of the $25,000 allowance in subsequent years. For example, suppose in the next year you have the same $6,000 rental loss. Your total loss including your carryforward would then be $7,000. If your MAGI in that year is under $136,000, you can claim the full $7,000 as a deduction in that year.

Use Form 8582 to compute and keep track of your PALs.