How are REITs taxed compared to direct real estate ownership?
Generally, no. For most real estate investors, rental real estate losses are treated as passive, and passive losses usually can offset only passive income, not wages, salaries, business income, interest, dividends or other nonpassive income.
The IRS explains that passive activities generally include trade or business activities in which the taxpayer does not materially participate, as well as rental activities regardless of participation.
Under the IRS framework, income and losses generally fall into two practical categories. Active income comes from work or business activities in which the taxpayer materially participates. Portfolio income includes items such as interest, dividends and many capital gains. Passive income generally comes from rental activities, limited partnerships or businesses in which the taxpayer does not materially participate. The distinction matters because the passive activity loss rules restrict when a real estate loss can reduce taxable income.
For rental real estate, the default rule is especially important. Even when an owner approves tenants, reviews repairs, manages cash flow or speaks with property managers, the activity may still be treated as passive unless an exception applies. That is where many investors get surprised. They feel active because they are involved. The tax law may still call the activity passive.
There are three main ways real estate investors may use losses more favorably.
First, passive losses can offset passive income from other passive activities. For example, if one rental property produces income and another produces a loss, the loss may offset the income, subject to the passive activity loss limitation and other passive activity rules. If losses exceed passive income, the unused amount generally becomes a passive loss carryforward to future years.
Second, some rental real estate investors may qualify for the special $25,000 allowance. This applies to individuals who actively participate in rental real estate and meet the income limits. Active participation is a lower standard than material participation and may include management decisions such as approving tenants, setting rental terms or authorizing repairs. The allowance phases out as modified adjusted gross income rises, so higher income taxpayers may receive little or no current benefit.
Third, a taxpayer who qualifies as a real estate professional may be able to treat rental losses as nonpassive, but only if the taxpayer also materially participates in the rental activity. The IRS standard generally requires more than 750 hours in real property trades or businesses and more than half of the taxpayer’s personal service time in those activities. This can be powerful, but it is also document heavy.
Another important rule applies when an investor sells the entire interest in a passive activity in a fully taxable transaction. Suspended losses connected to that activity may become deductible at that time. This is one reason buying, holding, improving and selling decisions should be modeled together rather than reviewed one property at a time.
Investors receiving a Schedule K-1 from a partnership, S corporation or LLC should pay close attention to how income, losses, basis and at-risk amounts are reported. A loss shown on the form is not automatically deductible.
Phantom Income can create another planning issue. An investor may owe tax on allocated income even when cash was not distributed, depending on the investment structure.
Carried Interest Tax questions are separate from passive loss deductibility, but they often arise in real estate fund planning and should be reviewed alongside holding periods and investor allocations.
The practical answer is this: passive activity losses can offset other income only when a specific exception applies. Otherwise, they offset passive income now, carry forward to future years or may be released when the investment is sold in a qualifying taxable disposition. For real estate investors, the planning opportunity is not merely finding deductions. It is matching the right deductions to the right income at the right time.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Rick Suid, Partner in Bennett Thrasher’s Financial Reporting & Assurance practice with extensive Real Estate industry experience, or call us at 770.396.2200.
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