The default rule
Your rental is passive. That is the starting point in the Internal Revenue Code, and it is why the loss on your Schedule E did not lower the tax on your W-2. Passive losses offset passive income. They do not touch salary, bonus, or RSU income.
Most investors find this out the first April after they buy. The property runs a paper loss thanks to depreciation, the return shows the loss, and the refund does not move.
The $25,000 allowance, and where it dies
There is a carve-out. If you actively participate in the rental, you can deduct up to $25,000 of losses against ordinary income. Active participation is a low bar: approving tenants, setting rents, approving repairs. You can use a property manager and still clear it.
The problem is the income phase-out. The allowance starts shrinking once modified adjusted gross income passes $100,000 and is gone at $150,000. On a Westside tech or physician salary, that door is already closed. Married filing separately is worse.
Real Estate Professional Status
REPS is where the rules actually change. Qualify and also materially participate in the rentals, and the losses can offset W-2 and other active income. Two tests, both required, both tested every year.
More than half of the personal services you perform in all trades or businesses during the year must be in real property trades or businesses where you materially participate. And more than 750 hours in those activities.
Note the first test. If you work 2,000 hours at a day job, you need more than 2,000 hours in real estate. That is why a full-time W-2 employee almost never qualifies alone. Where it works is a household with one spouse out of the workforce running the portfolio, since REPS is tested per spouse but the losses land on a joint return.
The hour tests count all your real estate work, whether or not you make any election. Where an election matters is material participation. A real estate professional has to materially participate in each rental unless they elect under Reg. §1.469-9(g) to treat all rentals as one activity. That election has consequences when you sell one property, so make it deliberately. Here's how to make the election, and when not to.
What REPS looks like under audit
REPS is a documentation fight, not a legal one. Examiners rarely argue about the statute. They ask for the hours, then they test them.
What holds up: a contemporaneous log with dates, the specific task, the property, and the time spent. What does not: a spreadsheet built in March from memory, round numbers, vague blocks of research time, or hours claimed on days your employer's records put you at a desk. Investor-type hours, meaning watching statements on a portfolio you are not running, do not count toward material participation.
Courts have thrown out plenty of REPS claims on the log alone. If you claim it, keep the log weekly and keep it boring. Here's what counts toward the hours and what a log that holds up looks like.
The losses are not lost
Losses you cannot use become suspended passive losses, tracked on Form 8582 and carried forward with no expiration. They free up when the activity throws off passive income, or when you sell the property in a fully taxable sale to an unrelated party, which releases the stack against your other income.
That timing matters. Suspended losses behind a property are a real asset at exit, and they interact with a 1031 exchange, which defers the gain and keeps the losses parked.
What I tell clients
Do not claim REPS because a podcast told you to. Look at the real hours in your household, decide before January whether the year can support the claim, then log it as you go. If REPS is out of reach, the value sits in cost segregation timing, the exit, and how the portfolio is held, not in a deduction you cannot use. If you do qualify, a large cost segregation loss can still run into the 2026 excess business loss cap.
If you are sitting on suspended losses and want to know what they are worth on the way out, bring last year's return and a rough hour count and we can look at it together.
Related reading: Spousal REPS: When One Spouse's Hours Free Up Rental Losses.