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I OFTEN RECEIVE letters and emails from retired individuals in need of financial advice. Many of their queries mention that they attended one of those ubiquitous free lunch seminars offered by investment advisors and estate planners.
While I could ask what enticed them to attend, I’ve already heard the answer lots of times. They fell for the seminar promoters’ promises of free gourmet meals, along with tips on how to earn excellent returns on their investments, eliminate market risk and grow their retirement funds.
I also could ask them to tell me what happened right after they finished their meals. I also already know that answer. They were pitched investments in rental properties and other kinds of tax shelters. The promoters assured them that they would acquire properties that generate IRS-approved losses.
According to the promoters, just how would such losses benefit the investors? They could use them to erase taxes on their income from, say, salaries and business profits. Wannabe landlords want me to answer pretty much the same questions. Are those assurances reliable? How much are they allowed to deduct for rental property losses?
My answers are always the same. Potential investors should recognize that these kinds of promises are red flags, because the IRS sets strict limits on losses from investments in tax shelter deals, such as limited partnerships. How much does the agency allow owners of rental properties to write off for losses? It all depends.
The IRS generally allows tax shelter losses only to be offset against income from similar investments. It prohibits the use of shelter losses to wipe out taxes on non-shelter income, such as wages and stock market profits. These tough anti-shelter restrictions are, however, subject to several exceptions for investors.
One of the exceptions authorizes limited relief for losses up to $25,000 suffered by relatively small-scale investors in rental properties, be they multi-family homes, condominiums, cooperative apartments or stores. To qualify, property owners must be “active” managers.
For most landlords, satisfying this stipulation is a slam dunk. All that they have to do is help make decisions on such essentials as approving new tenants, deciding rental terms and okaying capital or repair expenditures. What they needn’t personally do is mow lawns, make repairs or answer middle-of-the-night calls from tenants. As long as the owners actively participate, they can delegate day-to-day operations to managing agents or others hired to collect rents and run the properties.
If lower- and middle-income landlords meet these qualifications, they can offset as much as $25,000 of their annual rental losses against other income. Note that the ceiling drops from $25,000 to $12,500 for married persons filing separate returns who live apart for the entire year. The law bars any offset for married couples who live together and file separate returns.
Fat cats should forget about the write-off. The full $25,000 deduction is available only for individuals with adjusted gross incomes (AGI) below $100,000—before subtracting any shelter losses. More bad news: The offset phases out. It shrinks by $1 for every $2 of AGI beyond $100,000 and vanishes completely when AGI surpasses $150,000. Even more bad news: There’s no inflation indexing for these dollar limits. They haven’t increased since they were introduced by the Tax Reform Act of 1986, when Ronald Reagan was in the White House. Other fine print worth noting: The break is authorized solely for an investor who owns at least a 10% interest in the property.
Claiming rental losses increases the likelihood of investors’ returns drawing the attention of the tax enforcers. The IRS suspects that many investors are incorrectly deducting losses. Investors who undergo audits will likely have to provide proof of their active participation in management decisions, ownership of at least a 10% interest and correct computation of their deductions under the AGI test.
Julian Block wrote and practiced law in Larchmont, New York, and was formerly with the IRS as a special agent (criminal investigator). He died in 2023. Check out the articles that Julian wrote for HumbleDollar.
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