Many taxpayers wonder whether they can use losses from one income source—such as a rental property—to offset gains or earnings from another, like interest, dividends, or capital gains. This is especially important when looking for ways to lower taxable income and potentially generate a tax refund.
The short answer is: yes, in some cases, rental losses can offset investment income. However, the IRS imposes specific rules and limitations, especially around passive activity losses and how they interact with other income types. In this blog, we’ll dive into how this works, when it applies, and how to plan your tax strategy to maximize deductions and potential refunds.
1. Understanding Rental Income and Losses
Rental income is considered passive income by the IRS. This includes the income you earn from renting out property like houses, apartments, or commercial units. Along with income, you are also allowed to deduct various expenses related to managing and maintaining the property, such as:
- Mortgage interest
- Property taxes
- Repairs and maintenance
- Depreciation
- Insurance premiums
- HOA fees
- Utilities paid by the landlord
If these allowable deductions exceed your rental income for the year, you have a rental loss. But the ability to deduct this loss from other types of income is subject to IRS rules.
2. The Passive Activity Loss (PAL) Rules
The Passive Activity Loss rules (IRC Section 469) limit the ability to deduct rental losses against other types of income. In general, passive losses can only offset passive income—not active (e.g., wages) or portfolio (e.g., interest/dividends) income.
This means that you usually can’t deduct rental losses against investment income like capital gains, interest, or dividends, unless you meet one of several exceptions.
3. The $25,000 Special Allowance Exception
The IRS provides an exception to the PAL rules for active participants in rental real estate. If you meet this standard, you may be eligible to deduct up to $25,000 of rental loss against other types of income, including investment income.
Who Qualifies?
- Your modified adjusted gross income (MAGI) is $100,000 or less.
- You actively participate in the rental activity (e.g., make management decisions, approve expenses, select tenants).
- You own at least 10% of the rental property.
If your MAGI is between $100,000 and $150,000, the $25,000 allowance is phased out by 50 cents for every dollar over $100,000. Once your MAGI reaches $150,000, you can’t use this allowance at all.
4. Real Estate Professionals: Full Deduction Option
If you qualify as a real estate professional under IRS rules, the rental activity is no longer considered “passive,” and you may be able to deduct all losses without limitation—even against investment income.
Requirements to Qualify:
- You spend more than 750 hours per year in real estate trades or businesses.
- More than 50% of your working hours are in real estate activities.
- You materially participate in the rental activity (not just passive ownership).
This status is especially helpful for full-time landlords, real estate agents, brokers, and developers. It unlocks the ability to offset all income types, including capital gains, interest, and dividends.
5. Offset with Capital Gains: Is It Possible?
If you don’t qualify for the $25,000 exception or real estate professional status, rental losses are suspended and carried forward. But when you have passive capital gains—such as profits from selling a rental property or interests in other passive investments—these suspended rental losses can be used to offset those gains.
For example:
- You have $10,000 in suspended passive rental losses from prior years.
- You sell a passive partnership interest and realize a $15,000 gain.
- You can apply the $10,000 rental loss against the $15,000 gain.
Note: This only works with passive gains. You still can’t use these losses against portfolio income like stock dividends unless the underlying asset was also a passive activity.
6. Rental Losses and the Net Investment Income Tax (NIIT)
If your income is above a certain threshold, you may be subject to the Net Investment Income Tax (NIIT), which adds a 3.8% tax on investment income such as dividends, capital gains, and rental income.
In some cases, rental losses may help reduce your NIIT liability if they reduce net investment income below the threshold. However, only allowable deductions apply—suspended PALs do not help unless triggered by passive income or asset disposition.
7. How to Track and Report Rental Losses
You must report rental income and expenses annually on Schedule E (Form 1040). Any disallowed losses should be carried forward on Form 8582 (Passive Activity Loss Limitations).
Here’s what you’ll need to ensure proper tracking:
- Depreciation records and basis adjustments
- Receipts and documents for all expenses
- Rental income logs and tenant payment records
- Participation logs if claiming active or material participation
8. Unlocking Suspended Losses: The Disposition Rule
If you sell your entire interest in the rental property to an unrelated party, all previously suspended passive losses can be fully deducted in that tax year—regardless of your income level or activity status.
This strategy can result in a substantial deduction in the year of sale, helping offset other capital gains or taxable income. It’s a valuable planning tool for those with years of accumulated passive losses.
9. Tax Refund Potential: Bringing It All Together
Rental losses can lead to a refund if they reduce your total taxable income below what you paid in taxes throughout the year. For instance:
- W-2 income: $60,000
- Investment income: $10,000
- Rental loss: ($20,000)
- MAGI: $50,000 — qualifies for full $25,000 special allowance
- Result: Refund possible due to over-withholding on a now-lower income base
If you’re not eligible to offset other income now, your losses can still reduce future taxable gains or income. So while a refund may not come immediately, it may still come later when passive income or a property sale occurs.
10. Conclusion: Strategic Use of Rental Losses Can Reduce Taxes
You can’t always offset investment income with rental losses—but in the right circumstances, it’s absolutely possible. Taxpayers with moderate income and active rental involvement may benefit from the $25,000 special allowance. Real estate professionals can deduct losses more freely. And suspended passive losses can be strategically used to offset gains when you sell assets or your income profile changes.
If you’re serious about maximizing your refund or minimizing tax liability, consult a tax advisor. Rental income tax strategies are complex, and proactive planning can make all the difference.
