The IRS makes a distinction between certain types of income and expenses, especially those it considers a result of so-called passive activities.
Passive activity expenses are deductible only from passive activity income. If expenses exceed income, then the losses cannot be used to offset other income, such as payroll income.
Instead, the passive activity losses have to be carried forward and used in future tax years. Rental activities are considered passive activities.
For example, if you have $35,000 of expenses associated with rental properties (because of depreciation deductions) and only $12,000 of income, then you will pay no taxes on the $12,000. However, you cannot use the leftover $23,000 to reduce the taxable income from your day job.
The good news is that there are three exceptions.
1. Taxpayers may deduct up to $12,500 in passive losses (up to $25,000 for married couples) if they or their spouses actively participated in the real property activity.
2. If the rental is a dwelling that the taxpayer uses for more than fourteen days per year or 10% of the days the dwelling is available for rental (whichever is greater), then it does not count as a passive activity. This would be your beach house, for example.
3. The taxpayer is a real estate professional, which, for these purposes, means someone who performed more than 750 hours of services that year in real property trades or businesses in which he or she materially participated, and more than half the personal services the taxpayer performed in all trades or businesses was performed in real property trades or businesses.
That is a lot of technical IRS language. Converting it into plain English would take more pages than we can devote to the subject here. For more information, see IRS Publication 925, “Passive Activity and the At-Risk Rules,” and Tax Topic 425, “Passive Activities, Losses and Credits,” at the IRS website, www.irs.gov.