Updated on February 7, 2023 by David Korpel
Passive activity loss rules are part of the tax code and are designed to prevent taxpayers from using losses from passive activities, mainly rental properties, to offset income from their active trades or businesses. While the purpose of these rules is to prevent tax avoidance, they often end up becoming a trap for unsuspecting taxpayers, particularly those who earn more than $150,000 annually.
High earners need to be particularly aware of the passive activity loss (PAL) rules because they limit the amount of passive losses that can be used to offset taxable income. This means that if you have a rental property that generates a loss, you may not be able to use that loss to offset other income, including wages and salaries. This can result in taxpayers paying more taxes than they should, making the PAL rules a tax trap for high earners.
To better understand the PAL rules, let’s take a closer look at an example. Suppose you earn $200,000 from your day job and also have a rental property that generates a loss of $30,000, thanks to repairs, depreciation, and an insanely high-interest rate. If you’re subject to the PAL rules, you won’t be able to use the $30,000 loss to offset your $200,000 of taxable income. Instead, you’ll carry that $30,000 loss into next year, and the year after that. And the one after that. Until you have a net income from the rental property, after all of your expenses, to use to reduce that Passive Activity Loss that has been building up.
That’s the only time you are able to use that loss to reduce your income, against real estate rental income. Even when you sell the property, you cannot use the PAL, because capital gains are a separate income class from passive activities like rental real estate.
Remember, only if you are a real estate professional, working 750 hours or more per year, actively in real estate, these PAL rules do not apply to you. If you are not a real estate professional, you must adhere to these PAL rules regardless of your income.
The PAL rules are a tax trap for high earners for several reasons. Firstly, the rules can be complicated to navigate, with confusing calculations often resulting in taxpayers making costly mistakes. Secondly, even if you have a significant amount of passive income, you may still be subject to the PAL rules, which limit the amount of passive losses that can be used to offset taxable income. This can result in taxpayers paying more taxes than they should, even if they have significant passive income.
A tax professional can also help you understand the tax implications of owning a rental property, including the tax implications of depreciation, mortgage interest deductions, and other expenses associated with rental property ownership. They can also help you understand the tax implications of passive activity loss rules and how they may affect your overall tax liability. It’s important to remember that the tax code is constantly changing, and new rules and regulations can be introduced at any time. In conclusion, if you’re a high earner making over $150,000 annually, it’s essential that you understand the passive activity loss rules and how they can impact your taxes.
