Episode 137 of Concrete Numbers · 6 min watch
Rental real estate losses are passive by default, so they usually cannot offset your construction profits or wages. They can when you fit one of three routes: the $25,000 allowance for active participation at moderate income, real estate professional status, or a short-term rental you materially participate in. Losses that do not qualify are not lost; they carry forward.
The default rule: rental losses are passive
Under IRC §469(c)(2), any rental activity is a passive activity unless an exception applies. A passive loss can offset only passive income. Disallowed losses carry forward under §469(b) and stay tied to that activity, tracked on Form 8582.
This matters for contractors who add depreciation, especially after a cost segregation study or a look-back study filed on Form 3115. A bigger loss on paper only helps this year if it gets past the passive rules.
Path 1: the $25,000 allowance for active participation
If you actively participate in a rental real estate activity, §469(i) lets you deduct up to $25,000 of the loss against nonpassive income. Active participation is a lower bar than material participation. Approving tenants, setting rental terms and approving expenditures generally count, but you need at least a 10% interest by value.
The allowance shrinks by 50% of modified AGI over $100,000 and is gone at $150,000. If you are married filing separately and lived apart all year, the cap is $12,500 and the phase-out runs from $50,000 to $75,000. If you lived together at any time during the year, there is no allowance.
Hypothetical: with modified AGI of $120,000, the allowance drops by $10,000 (50% of $20,000), leaving $15,000. Many profitable contractors are above $150,000, where it is zero.
Path 2: real estate professional status
Under §469(c)(7), rental real estate is not automatically passive for a qualifying taxpayer. You qualify for the year only if more than half of the personal services you performed in all trades or businesses were in real property trades or businesses in which you materially participate, and those hours total more than 750.
The statute lists construction and reconstruction as real property trades or businesses, alongside development, rental, management and brokerage. So hours running your own construction company can count. Hours worked as an employee count only if you are a 5-percent owner of the employer, which is the rule to check if you are on payroll in your own S corporation. A W-2 job outside real estate counts against you in the half test.
On a joint return, one spouse must meet both tests alone; your spouse’s services do not count toward your tests. The channel’s separate REPS videos, listed on the Concrete Numbers podcast page, go deeper on these tests.
Qualifying is not enough: material participation in the rental
A real estate professional must also materially participate in the rental activity itself. Each rental interest is a separate activity unless you elect under §469(c)(7)(A) to treat all of them as one. The election is made with a statement attached to your original return, and Rev. Proc. 2011-34 allows a late election in some cases. For material participation, your spouse’s participation does count.
Reg. §1.469-5T(a) sets out seven tests. Common ones are more than 500 hours, doing substantially all of the work, or more than 100 hours and at least as much as anyone else. Applying these tests to your real calendar is part of the tax planning and accounting work we do for contractors.
Path 3: short-term rentals
Under Reg. §1.469-1T(e)(3)(ii), property is not a rental activity for these rules if the average period of customer use is seven days or less, or 30 days or less when significant personal services are provided. It is then treated like any other business: losses are nonpassive only if you materially participate, with no real estate professional status required.
If a property manager works more hours than you, the 100-hour test is not met.
Documenting your hours
Reg. §1.469-5T(f)(4) allows participation to be shown by any reasonable means, and daily logs are not strictly required; appointment books, calendars and narrative summaries can support it. Still, a log kept as you go (date, property, task, time) beats a reconstruction after a notice arrives. Build it into your bookkeeping records, keep it under your record retention rules, and expect large rental losses to draw the kind of questions covered in our audit triggers episode.
When suspended losses come back, and the limit after that
Suspended losses are released when you dispose of your entire interest to an unrelated person in a fully taxable transaction, one where all realized gain or loss is recognized. A 1031 exchange that defers gain does not meet that test.
Clearing the passive rules does not end it. Under the Form 461 instructions, the at-risk rules apply first, then the passive loss rules, then the excess business loss limit under §461(l), which the One Big Beautiful Bill Act made permanent. A disallowed excess business loss carries forward as a net operating loss.
California does not follow real estate professional status
California Revenue and Taxation Code §17561 says §469(c)(7) does not apply, and the FTB 3801 instructions state that for California all rental activities are passive. A loss you deduct federally as a real estate professional can therefore be suspended on your California return and tracked on Form FTB 3801. Otherwise California generally follows the federal rules, including the $25,000 allowance. Our state and local tax episode covers other California differences.
Frequently asked questions
Can my rental losses offset my construction company income?
Only through an exception: the $25,000 allowance below $150,000 of modified AGI, real estate professional status plus material participation, or a short-term rental you materially participate in. Otherwise they carry forward. Our episode on deductions contractors miss covers other items worth checking.
Do hours in my construction company count toward real estate professional status?
They can, because construction is a real property trade or business under the statute. Hours worked as an employee count only if you are a 5-percent owner of the employer, and you still need material participation in the rental itself.
What happens to rental losses I cannot use this year?
They carry forward to later years and stay tied to that activity. They are released when you dispose of your entire interest to an unrelated person in a fully taxable transaction. See our episode on depreciation recapture for the other side of a sale.
Does California allow the real estate professional exception?
No. For California, all rental activities stay passive, so a loss allowed federally may be suspended on the California return.
Can your rental losses offset other income?
We can review your rentals, hours and income against the federal and California passive loss rules before you file. Book a call to walk through your facts.
Verified against IRC §469 and §461(l), Treas. Reg. §§1.469-1T, 1.469-5T and 1.469-9, IRS Publication 925, the IRS instructions for Form 8582, Schedule E and Form 461, California R&TC §17561 and the FTB Form 3801 instructions. General information, not advice for your situation.