Can I deduct rental property renovation expenses on my tax return? Difference between Ordinary Business Income and Real Estate Rental Income on K-1 passthrough

Yes, there is a significant difference between Ordinary Business Income and Real Estate Rental Income on your K-1, and it impacts how the losses flow through to your personal return. Rental real estate income/losses from a partnership typically appear in Box 2 of Schedule K-1 and flow to Schedule E of your personal return. These are considered passive activity losses. The big catch here is that passive losses can only offset passive income, unless you qualify as a real estate professional or meet the exception for active participation with income below certain thresholds. Ordinary business income/losses (Box 1 on K-1) generally flow through as non-passive and can offset your other income sources more freely. Your renovation expenses are correctly classified as rental real estate expenses since they're related to a rental property, regardless of whether you've generated rental income yet. Just because you haven't had tenants doesn't change the nature of the activity - it's still considered a rental real estate activity in the eyes of the IRS.

I was in almost the exact same situation last year with my duplex purchase through my LLC. I spent hours trying to figure out the tax implications and finally discovered taxr.ai (https://taxr.ai) which really helped me understand the K-1 passthrough implications. You upload your forms and it breaks down exactly how rental property losses flow through from partnerships to personal returns and highlights the passive activity limitations. What frustrated me initially was that Turbotax kept flagging my rental losses as potentially limited, but didn't explain WHY or what I could do about it. The taxr.ai system actually showed me the calculation for the $25,000 special allowance and confirmed I could use most of my losses in the current year because my income was under the threshold.

Just wanted to follow up about using taxr.ai that I mentioned above. I decided to try it with my partnership K-1 that had similar rental property losses. Honestly, I was really surprised by how helpful it was. It explained that my renovation expenses were indeed capitalized as part of the property basis rather than immediately deductible (something my partner had been arguing with me about). It also clarified how the passive activity loss limitations applied to my specific situation based on my income and level of participation. This saved me a ton of research time and I was able to bring the analysis to my tax preparer who confirmed it was correct. Definitely made the whole process less stressful than last year's tax nightmare with the same rental issues.

A bit off-topic but this reminds me of when I had a similar issue with rental property losses. I spent WEEKS trying to get someone at the IRS to confirm how these should be treated on my personal return. Impossible to get through on the phone until I found Claimyr (https://claimyr.com). They have this system that holds your place in the IRS phone queue and calls you when an agent is about to answer. You can see it in action here: https://youtu.be/_kiP6q8DX5c Got through to an IRS agent in about 45 minutes (after trying for days on my own). The agent confirmed that rental property losses on K-1 are subject to passive activity loss limitations but also explained the exceptions in detail for my situation. Saved me from making a big mistake on my return!

Ok I have to eat my words. After waiting on hold with the IRS for 3+ hours yesterday and getting disconnected, I tried that Claimyr service out of desperation. Got connected to an IRS representative in under an hour! The agent walked me through exactly how partnership rental losses pass through on Schedule E and the passive activity loss worksheets. For anyone dealing with K-1 rental losses - make sure you understand whether you're "actively participating" in the rental - it makes a huge difference in whether you can use that $25,000 exception. The agent confirmed that making decisions about renovations, approving expenses, and setting rental terms counts as active participation even if you have a management company.

Something nobody's mentioned yet - some of those renovation expenses might need to be capitalized and depreciated rather than deducted immediately. Items that are improvements (like a new roof or addition) must be depreciated over 27.5 years for residential rental property, while repairs can be deducted in the current year. The partnership return should handle this distinction, but it's worth checking to make sure they've properly classified your expenses. This could affect how much of a loss you're seeing on the K-1.

Random question - has anyone used the new safe harbor for small rental activities? I think if your adjusted basis in the property is under a certain amount, you can potentially avoid some of the passive activity loss limitations. Worth looking into maybe?

One thing that might help clarify your situation - since you mentioned this is through an LLC partnership, make sure you understand your ownership percentage and how that affects the losses flowing through to you personally. If you're not a 100% owner, your K-1 will only show your proportionate share of the $38,000 in renovation expenses. Also, keep detailed records of any time you spend managing this rental property (even during renovation phase) - hours spent coordinating contractors, researching materials, visiting the property, etc. This documentation becomes crucial if you want to qualify for the active participation exception or potentially the real estate professional status in future years. The fact that you haven't had tenants yet doesn't disqualify you from the rental activity treatment, but it does mean you'll want to be extra careful about demonstrating that this is indeed intended as a rental business and not just a personal investment that might be reclassified by the IRS.