If you own rental real estate, you re likely to run up tax losses in this economic environment. However, your ability to actually deduct those losses might be postponed -- or not. Here s what you need to know.

As a general rule, tax losses from owning rental real estate are treated as passive activity losses, or PALs. That s not a good thing because you can only deduct PALs to the extent you have passive income (such as income from other healthier rental properties or gains from sales of rental properties). Unfortunately, many owners have little or no passive income, so most or all of their PALs are suspended and carried over to future years. You can deduct suspended PALs when you have passive income or when you sell the properties that generated the PALs, but that might be years from now.

Don t give up hope, though, because there are two favorable exceptions to the general rule.

Exception 1: Active Landlords

The most widely available exception allows you to deduct up to $25,000 of rental property PALs if: (1) your modified adjusted gross income (MAGI) is no more than $100,000 (the $100,000 limit applies whether you re a married joint filer or unmarried) and (2) you actively participate in the property. Active participation means owning at least a 10% stake and making management decisions like approving tenants, signing leases, authorizing repairs and so forth. You don t have to mow lawns or snake out drains. But if you use a management company to handle all the details, you ll fail the active participation test, and this exception will be off limits.

If your MAGI falls between $100,000 and $150,000, this exception is phased out pro-rata. For example, if your MAGI is $125,000, you can deduct up to $12,500 of PALs from rental properties in which you actively participate (half the $25,000 maximum). Once your MAGI hits $150,000, however, this exception is completely disallowed, and you fall back under the general anti-taxpayer PAL rule.

Exception 2: Real Estate Pros

This second exception is only available to folks who I call real estate professionals. To be eligible, you must spend over 750 hours during the year on real estate activities in which you materially participate (not counting your spouse s time if you re married). And those 750 hours must be over half the time you spend performing personal services (in other words, working) during the year. If you clear these hurdles, losses from rental properties in which you materially participate are not PALs, and you can generally deduct them in the year they are incurred.

Passing the material participation test is harder than passing the Exception 1 active participation test. The three most likely ways to pass are by:

1. Making sure the time you spend on your rental property during the year constitutes substantially all the time spent by all individuals.

2. Spending more than 100 hours on your property and making sure no other individual spends more time than you.

3. Spending more than 500 hours on the property.

You only have to meet one of these three requirements to pass the material participation test. If you re married, you can combine your hours with your spouse s. If you own multiple rental properties, you can choose to treat them all as one activity, and then count the combined hours spent on them all to meet any of the three requirements. (That said, check with your tax advisor before combining properties, because doing so can have a negative side effect if you later sell properties with suspended PALs.)

Special Rule for Properties in Resort Areas

If your rental property is in a resort area, the average rental period may be seven days or less during the year. In this seven-day-rental scenario, the IRS says you re running a hotel-like business as opposed to innocently renting out your property. That makes you ineligible for both exceptions above. However, if you materially participate in the property, your tax losses are not PALs, and you can generally deduct them in the year they are incurred.

You can pass the material participation test by meeting any one of the three requirements I listed above, in the section on Real Estate Pros.

For the story on what happens when you sell a rental property, click here

For More Information

The tax rules for rental property losses are tricky, and I ve left out some details to keep this from turning into a book. For more information, check out IRS Publication 527 (Residential Rental Property).