Can I deduct losses on my income tax return?

Losses are deductible up to the amount of “adjusted basis” which is the original cost of the property plus improvements or additions. However, individuals cannot deduct losses unless they are either:

(1) incurred in a trade or business,

(2) incurred in a transaction entered into for profit,

(3) arising from fire, storm, shipwreck or other casualty,  or

(4) from theft.

Deductible losses do not include losses from the sale of capital assets, like stocks and other investment securities. Those are capital losses to which special rules apply.

Casualty losses are subject to certain limitations. First, the first $100 of each loss is not deductible. Second, all net casualty losses are deductible only if they exceed 10% of the taxpayer’s adjusted gross income (which is income before itemized deductions and exemptions). There are special rules for disaster losses. The purposes of these limitations is to limit casualty losses to those that are substantial for the particular taxpayer. More on casualty losses can be found in IRS Pub 17.

Passive activity losses are generally limited to passive activity income.  Passive activity income would be a trade or business where the taxpayer did not actively participate.  For example, if someone becomes a silent partner in their son’s business, that would be considered a passive activity and any passive losses could only be taken against passive income.  However those losses would carry forward and if that taxpayer eventually sold his share of the partnership to his son, the losses could be taken at that time. Read more on passive activity losses in Tax Topic 425.

Losses from rental real estate activities can also be limited.  Rental real estate is considered to be a passive activity even if the taxpayer is actively involved in managing and maintaining the property.  However, losses up to $25,000 ($12,500 for married filing separately) can be deducted against other income, in any one tax year, as long as the taxpayer actively participates in managing and maintaining the property.  There is, however, an AGI (adjusted gross income) phase out, on a scaled basis, for rental real estate losses.  The phase out begins at an AGI of $100,000.00 ($50,000.00 for married filing separately) and phases out completely at an AGI of $150,000.00 ($75,000.00 for married filing separately).

Case Studies: Deducting Losses on Income Tax Returns

Case Study 1: Casualty Losses

Jane’s home was severely damaged in a storm, resulting in significant repair costs. She incurred a casualty loss due to the storm damage. After calculating the adjusted basis of her property, Jane discovers that the casualty loss exceeds 10% of her adjusted gross income. As a result, she can deduct the portion of the loss that exceeds the 10% threshold from her income tax return.

Case Study 2: Passive Activity Losses

Michael invested in a partnership as a silent partner. The partnership generated passive activity losses, but Michael’s share of the losses can only be deducted against passive income. Since Michael does not have sufficient passive income to offset the losses, he carries forward the losses to future years. If he eventually sells his share of the partnership, he can use the carried-forward losses to reduce his taxable income at that time.

Case Study 3: Rental Real Estate Losses

Sarah owns several rental properties and actively manages them. In a particular tax year, she incurs rental real estate losses. Since Sarah actively participates in managing and maintaining the properties, she can deduct up to $25,000 ($12,500 for married filing separately) of rental real estate losses against her other income.

However, there is an adjusted gross income (AGI) phase-out, and the deduction is gradually reduced for AGIs between $100,000 and $150,000 (or $50,000 and $75,000 for married filing separately).