1

STUDY UNIT THREE

RENTAL PROPERTY AND LOSS LIMITATIONS

3.1 Rental Property Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

3.2 Rental Property Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3.3 Loss Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

The first two subunits discuss the items included in rental property income and expenses. The last
subunit discusses loss limitations associated with at-risk rules and passive activity rules.

3.1 RENTAL PROPERTY INCOME

1. Cash or the fair market value (FMV) of property or services received for the use of real estate or
personal property is taxable as rental income.
a. Rent from real estate is income from an investment, not from the operation of a business.
b. Schedule E is not used to report income and expenses from the rental of personal
property, such as equipment or vehicles. Instead, Schedule C is used if the taxpayer
is in the business of renting personal property. A taxpayer is in the business of renting
personal property if the primary purpose for renting the property is income or profit and
the taxpayer is involved in the rental activity with continuity and regularity. If rental of
personal property is not a business, any income belongs on Form 1040 (Schedule 1).
c. A bonus received by a landlord for granting a lease is included in gross income.
d. A lessee’s refundable deposit intended to secure performance under the lease is not
income to the lessor.
e. Value received by a landlord to cancel or modify a lease is gross income.
1) Amounts received by a lessee to cancel a lease, however, are treated as amounts
realized on disposition of an asset or property (a capital gain).
f. An amount paid by a lessee to maintain the property in lieu of rent, e.g., for property tax, is
gross income to the lessor.
1) The lessor includes the payment in gross income and may be entitled to a
corresponding deduction, e.g., property tax deduction.

EXAMPLE 3-1 Payments of Lessee in Lieu of Rent

While a taxpayer is out of town, the furnace in the taxpayer’s rental property stops working. The tenant pays
for the necessary repairs and deducts the repair bill from the next rent payment. The repair bill paid by the
tenant and any amount received as rent payment are included as rental income. The taxpayer may deduct
the repair payment made by the tenant as a rental expense.

g. The FMV of lessee improvements made to the property in lieu of rent is also gross income
to the lessor.
1) The FMV of the lessee improvements are also allowable as a deduction in the
computation of income from the rental activity.
h. The value of lessee improvements that are not made in lieu of rent is excluded from the
lessor’s gross income.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
2 SU 3: Rental Property and Loss Limitations

i. Prepaid rent is included in gross income when received (the same as for cash-method
and accrual-method taxpayers).
1) Lease cancellations are included.
2) Tenant improvements, in lieu of rent, are included.
3) Security deposits are not considered income when the property owner is obligated to
return them to the tenants.
4) Advance rental payments must be deducted by the payee during the tax periods to
which the payments apply.
j. Rental income from a residence is included in gross income unless the residence is rented
out for less than 15 days in a given year.
1) If rental income is excluded from gross income, the corresponding rental deductions
are also disallowed.
k. Rental income received by an individual where no significant services are provided should
be reported along with any respective rental expenses on Schedule E (Form 1040).
1) If significant services are provided, the rental income and expenses should be
reported on Schedule C (Form 1040).
l. Income and expenses from business should be reported on Schedule C, Profit or Loss
From Business.
Not-for-Profit Rental Income
2. If property is not rented to make a profit, taxpayers can deduct their rental expenses only up to
the amount of their rental income. A taxpayer cannot deduct a loss or carry it forward to the next
year if rental expenses are more than rental income for the year.
a. Not-for-profit rental income is reported on Form 1040 or 1040-NR. Taxpayers can include
their mortgage interest (if the property is used as their main home or second home), real
estate taxes, and casualty losses on the appropriate lines of Schedule A if they itemize
their deductions.
b. If rental income is more than rental expenses for at least 3 years out of a period of
5 consecutive years, taxpayers are presumed to be renting property to make a profit.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
 SU 3: Rental Property and Loss Limitations 3

3.2 RENTAL PROPERTY EXPENSES

1. Expenses related to the production of rental income are generally deductible to arrive at adjusted
gross income.
a. Rental property expenditures may be deducted by depreciation. Generally, a Sec. 179
deduction includes certain depreciable tangible personal property used predominantly to
furnish lodging or in connection with furnishing lodging.

2. Generally, repair and maintenance expense is considered a current-period deduction. However,

certain repairs may be classified as improvements, which must be capitalized. There are safe
harbor rules that allow repairs and maintenance to always be classified as current-period
expenses instead of capitalized.
a. Taxpayers who have elected to use the de minimis expense treatment must expense all
repairs up to the de minimis amount (i.e., $2,500).
b. The costs of performing certain routine maintenance activities for property may result in an
improvement to the unit of property, the costs of which must be capitalized.
1) However, a safe harbor rule allows routine repairs and maintenance to be expensed.
This safe harbor rule applies to actions that maintain the asset and are reasonably
expected to be performed more than once for the asset’s class life under the
alternative depreciation system.
3. Special rules limit deductions on the rental of a residence or a vacation home.
Minimum Rental Use
a. The property must be rented for more than 14 days during the year for deductions to be
allowable.
1) When the residence is rented for less than 15 days, the rental income does not need
to be reported.
Minimum Personal Use
b. The vacation-home rules apply when the taxpayer uses the residence for personal
purposes for the greater of (1) more than 14 days or (2) more than 10% of the number of
days for which the residence is rented.
4. A residence is deemed to have been used by the taxpayer for personal purposes if the home is
used by
a. The taxpayer for personal purposes, by any other person who owns an interest in the
rental property, or by the relatives of either
1) However, if the taxpayer rented or tried to rent the property for 12 or more
consecutive months, the days during which (s)he used the property as a main
home do not count as personal days.
b. Any individual under a reciprocal arrangement, whether or not rent is charged
c. Any individual unless a fair rental is charged
5. If the taxpayer spends substantially full-time repairing or maintaining the rental property, such
time does not count toward the personal-use test. This is the case regardless of use of property
by other family members.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
4 SU 3: Rental Property and Loss Limitations

Vacation Home Rules

6. If the property passes the minimum rental-use test but fails the minimum personal-use test, the
property is considered a vacation home, and rental deductions may not exceed gross income
derived from rental activities.
a. Expenses must be allocated between the personal use and the rental use based on the
number of days of use of each.
b. When deductions are limited to gross income, the order of deductions is
1) The allocable portion of expenses deductible regardless of rental income (e.g.,
mortgage interest and property taxes)
2) Deductions that do not affect basis (e.g., ordinary repairs and maintenance)
3) Deductions that affect basis (e.g., depreciation)

EXAMPLE 3-2 Order of Deductions

A taxpayer with $4,000 of rental income, $2,000 of interest and taxes, $1,000 of repairs, and $10,000 of
depreciation may only deduct $1,000 of depreciation.
Income $ 4,000
Interest and taxes (2,000)
Repairs (1,000)
Depreciation (1,000)
$ 0

c. Any losses disallowed may be carried forward.

7. If the property passes both the minimum
Minimum Use Tests
rental-use test and the minimum
personal-use test, then all deductions Rental Use Personal Use
may be taken and a loss may occur, Pass > 14 days ≤ 14 days or < 10%
subject to the passive loss limits. Fail ≤ 14 days greater of > 14 days or > 10%

EXAMPLE 3-3 Mixed Use of Real Property

Jack owns a vacation condo on Miami Beach. He rents it out to vacationers most of the year but uses it
himself a few times each year. In each of the following situations, Jack has a different ability to deduct
expenses based on the amount of personal and rental use.
Situation 1: Jack uses the condo for 4 days and rents it for 200 days at fair rental value to unrelated parties.
In this situation, Jack passes the rental-use and personal-use tests and is able to take all deductions
applicable, subject to the passive loss rules.
Situation 2: Jack uses the condo for 24 days and rents it for 165 days at fair rental value to unrelated parties.
Jack passes the rental-use test but fails the personal-use test because he personally used the rental for the
greater of 14 days or 10% of the rental days. Therefore, Jack must allocate the expenses between rental use
and personal use and may deduct rental expenses to the extent of rental income.
Situation 3: Jack uses the condo for 10 days and rents the condo for 10 days at fair rental value to unrelated
parties. Because he fails the rental-use test, he does not need to report the rental income, but he may not
deduct the related rental expenses.

8. Expense deductions for not-for-profit (NFP) rentals are limited to income from such rentals.
Neither loss nor carryforward is allowed for NFP expenses in excess of NFP income.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
 SU 3: Rental Property and Loss Limitations 5

3.3 LOSS LIMITATIONS

1. A taxpayer’s deductible loss is limited to the smallest amount of the following limitations:
a. The taxpayer’s basis in the activity
b. The at-risk rules
c. The passive activity rules

EXAMPLE 3-4 Business Activity Loss

A taxpayer who owns both a lumber business and a boat for personal use incurred two losses during the
tax year upon selling both the boat and the lumberyard to a colleague. Though the combined loss totaled
$10,000, only the portion attributable to the business is potentially deductible. Losses on sales of property
held for personal use are not deductible.

At-Risk Rules
2. The amount of a loss allowable as a deduction is limited to the amount a person has at risk in the
activity from which the loss arose.
a. A loss is any excess of deductions over gross income attributable to the same activity.
b. The rules apply to individuals, partners in partnerships, members in limited liability
companies, shareholders of S corporations, trusts, estates, and closely held
C corporations.
1) Personal holding companies, foreign personal holding companies, and personal
service corporations are not subject to at-risk rules.
c. The at-risk rules are applied separately to each trade or business or income-producing
activity.
d. A person’s amount at risk in an activity is determined at the close of the tax year.
1) A person’s initial at-risk amount includes money contributed, the adjusted basis (AB)
of property contributed, and borrowed amounts.
2) Recourse debt requirements include the following:
a) A person’s at-risk amount includes amounts borrowed only to the extent that,
for the debt, the person has either personal liability or property pledged as
security (no more than the FMV when pledged minus prior or superior claims
is included).
b) The at-risk amount does not include debt if one of the following applies:
i) Property pledged as security is used in the activity.
ii) Insurance, guarantees, stop-loss agreements, or similar arrangements
provide protection from personal liability.
iii) A person with an interest in the activity or one related to him or her
extended the credit.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
6 SU 3: Rental Property and Loss Limitations

3) Nonrecourse debt is generally excluded from the amount at risk.

a) The amount at risk in the activity of holding real property includes qualified
nonrecourse financing (QNRF).
b) In qualified nonrecourse financing, the taxpayer is not personally liable, but the
financing is
i) Used in an activity of holding real estate;
ii) Secured by the real property;
iii) Not convertible to an ownership interest; and
iv) Either obtained from an unrelated third party, obtained from a related
party but on commercially reasonable terms, or guaranteed by a
governmental entity.

EXAMPLE 3-5 Nonrecourse Debt

Kathy purchased a small apartment building for $200,000 using $25,000 of her own money and $25,000
borrowed from her father to make the down payment. She signed a note to pay the remainder of the
purchase price to the seller. The debt to the seller was nonrecourse, secured only by the apartment building.
Kathy is not at-risk for the loan from the seller because the seller is a person from whom the taxpayer
acquired the property.

EXAMPLE 3-6 At-Risk Rules

Mooch purchased rental real estate with some money borrowed from his mother at commercially reasonable
terms and the rest of the money borrowed from the seller. Both loans were nonrecourse and only secured by
the property. Mooch is at risk for the loan from his mother because of the commercially reasonable terms and
the nonrecourse loan is for real property. Regardless of the terms, Mooch is not at risk for the seller’s loan.

4) Adjustments to an at-risk amount are made for events that vary the investors’
economic risk of loss.
a) Add contributions of money and property (its AB), recourse debt increases,
QNRF increases, and income from the activity.
b) Subtract distributions (e.g., from a partnership), liability reductions (recourse or
QNRF), and tax deductions allowable (at year end).
5) Disallowed losses are carried forward.
6) If the amount at risk decreases below zero, previously allowed losses must be
recaptured as income.
7) If a deduction would reduce basis in property and part or all of the deduction is
disallowed by the at-risk rules, the basis is reduced anyway.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
 SU 3: Rental Property and Loss Limitations 7

Passive Activity Loss (PAL) Limitation Rules

3. The amount of a loss attributable to a person’s passive activities is allowable as a deduction
or credit only against, and to the extent of, gross income or tax attributable to those passive
activities (in the aggregate).
a. The excess is deductible or creditable in a future year, subject to the same limits.

EXAMPLE 3-7 PAL Limitation

A wealthy taxpayer invested in an architecture partnership as a passive investor. Because the taxpayer does
not engage in the business outside of occasional business consulting, any income or loss derived from the
business is passive in nature. Therefore, any losses derived from the partnership may only offset passive
activity gains.

4. The passive activity rules apply to individuals, estates, trusts, personal service corporations, and
closely held corporations.
a. Although passive activity rules do not apply to grantor trusts, partnerships, and
S corporations directly, they do apply to the owners of these entities.
5. A passive activity is either rental activity or a trade or business in which the person does not
materially participate.
a. A taxpayer materially participates in an activity during a tax year if (s)he satisfies one of
the following tests:
1) Participates more than 500 hours
2) Participation constitutes substantially all of the participation in the activity
3) Participates for more than 100 hours and exceeds the participation of any other
individual
4) The activity is a significant participation activity in which the taxpayer participates
more than 100 hours and the taxpayer’s participation in all significant participation
activities exceeds 500 hours
5) Materially participated in the activity for any 5 years of the 10 years preceding the
year in question
6) Materially participated in a personal service activity for any 3 years preceding the
year in question
7) Satisfies a facts and circumstances test proving that the taxpayer participated on a
“regular, continuous, and substantial” basis
a) A taxpayer will not be considered to have materially participated in an activity
under this test if (s)he participated in the activity for 100 hours or less during
the year.

EXAMPLE 3-8 Business Passive Activity Loss

For 2021, Sally realized a $10,000 net loss (sales of $95,000 less expenses of $105,000) from operating a
sole proprietorship, without regard to dispositions of property other than inventory. The income tax return
also showed gross income of $5,000 ($2,500 of wages, $500 interest on personal savings, and a $2,000
long-term capital gain on business property). The excess of deductions over income was $18,550 ($5,000
gross income – $10,000 loss from business operations – $1,000 nonbusiness short-term capital loss on the
sale of stock – $12,550 standard deduction).
Because she does not engage in the business outside of occasional business consulting, any income or loss
derived from the business is passive in nature. Therefore, any losses derived from the partnership may only
offset passive activity gains.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
8 SU 3: Rental Property and Loss Limitations

6. Rental Real Estate

a. All rental activity is passive.
b. Up to $25,000 of a tax year loss from rental real estate activities in excess of passive
activity gross income is deductible against portfolio or active income.

EXAMPLE 3-9 PAL Limitation -- Rental Real Estate Activities

A taxpayer has wages of $30,000, $5,000 gain from a passive partnership interest, and $35,000 loss from
active rental real estate activity. The taxpayer may first offset the passive gain (i.e., $5,000) with $5,000 of
the passive loss. With the remaining $30,000 passive loss, $25,000 of the nonpassive gain (i.e., wages) may
be offset.

1) The $25,000 limit is reduced by 50% of the person’s MAGI [i.e., AGI without regard
to PALs, Social Security benefits, and qualified retirement contributions (e.g., IRAs)]
over $100,000.
2) Excess rental real estate PALs are suspended. They are treated as other PALs
carried over.

EXAMPLE 3-10 PAL Limitation -- Active Participation

Lynne, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, and a $26,000
loss from rental real estate activities in which she actively participated and is not subject to the modified
adjusted gross income phase-out rule. She can use $15,000 of her $26,000 loss to offset her $15,000
passive income from the partnership. She actively participated in her rental real estate activities, so she can
use the remaining $11,000 rental real estate loss to offset $11,000 of her nonpassive income (wages).

EXAMPLE 3-11 Allowed Rental Loss

A married taxpayer filing jointly actively participated in rental activity and incurred a rental loss of $30,000 in
the current year. If the taxpayer’s MAGI is $120,000, what is the amount of rental loss that is deductible?
MAGI $120,000 Loss limit $25,000
Threshold (100,000) Reduction (10,000)
Excess $ 20,000 Allowed loss $15,000
Reduction % × 50%
Reduction $ 10,000

c. This exception to the general PAL limitation rule applies to a person who
1) Actively participates in the activity,
2) Owns 10% or more of the activity (by value) for the entire year, and
3) Has MAGI of less than $150,000 [phaseout begins at $100,000; as discussed in
b.1) above].
d. Active participation is a less stringent requirement than material participation.
1) It is met with participation in management decisions or arranging for others to
provide services (such as repairs).
2) There will not be active participation if at any time during the period there is
ownership of less than 10% of the interest in the property (including the spouse’s
interest).

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.
 SU 3: Rental Property and Loss Limitations 9

e. Real property trades or businesses rules include the following:

1) The passive activity loss rules do not apply to certain taxpayers who are involved in
real property trades or businesses.
2) An individual (real estate professional) may avoid passive activity loss limitation
treatment on a rental real estate activity if the following requirements are met:
a) More than 50% of the individual’s personal services performed during the year
are performed in the real property trades or businesses in which the individual
materially participates.
b) The individual performs more than 750 hours of service in the real property
trades or businesses in which the individual materially participates.
3) This provision also applies to a closely held C corporation if 50% of gross receipts
for the tax year are from real property trades or businesses in which the corporation
materially participated.
4) Any deduction allowed under this rule is not taken into consideration in determining
the taxpayer’s AGI for purposes of the phaseout of the $25,000 deduction.
5) If 50% or less of the personal services performed are in real property trades or
businesses, the individual will be subject to the PAL limitation rules.
f. PALs continue to be treated as PALs even after the activity ceases to be passive in a
subsequent tax year, except that it may also be deducted against income from that
activity.
g. Disposition of a passive activity is subject to the following rules:
1) Suspended (and current-year) losses from a passive activity become deductible
in full in the year the taxpayer completely disposes of all interest in the passive
activity.
2) The loss is deductible first against net income or gain from the taxpayer’s other
passive activities. The remainder of the loss, if any, is then treated as nonpassive.
Excess Business Loss
7. After passing the at-risk limit and the passive activity loss rule, non-C corporate business losses
are now subject to the excess business loss limit. C corporations are excluded from this
limitation and allowed to offset pass-through losses received from pass-through entities against
non-business income (e.g., capital gains).
a. Excess business loss is calculated as follows:
All deductions from trades or businesses
Gross income or gain from trades or businesses
+ $250,000 ($500,000 MFJ) floor
Limitation – Limitation
= Excess business loss

b. The excess business loss is carried forward as an NOL. In carryover years, the NOL is
limited to 80% of the years’ TI.

Copyright © 2022 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact copyright@gleim.com.