The treatment of losses from rental real estate as ordinary losses rather than passive losses can potentially have a huge tax impact. Ordinary losses can be used to offset other ordinary income, such as wages, dividends, and other nonpassive income. Losses from passive activities can only be used to offset other passive income. Unused passive losses are suspended and carried over until there is either passive income to offset the passive losses, or the activity is entirely disposed.
In general, a rental real estate business is considered a passive activity. In order to treat losses derived from rental real estate as ordinary, a taxpayer must be considered a real estate professional and must materially participate in the rental activity. Under Internal Revenue Code Section 469, two tests must be met in order to be classified as a real estate professional for tax purposes:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer material participates.
In the case of a joint return, the above requirements are satisfied if either spouse separately satisfies such requirement.
Material participation is defined within the Internal Revenue Regulations and consists of seven requirements to consider:
- The individual participates in the activity for more than 500 hours during such year.
- The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interest in the activity) for such year;
- The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
- The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
- The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
- Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.
Proving the hours claimed and time involved can be a difficult hurdle in trying to establish the real estate professional and material participation standards. Keeping contemporaneous records, daily time logs, diaries, etc. are sometimes the best way to prove these standards in the case of an IRS audit.
In order to meet the real estate professional and material participation test, a taxpayer can elect to aggregate all interest in rental real estate as a single activity. This election can be made any year, but once the election is made, it is irrevocable unless there is a material change to the taxpayer’s facts and circumstances. This can be advantageous, because it can allow the taxpayer to take ordinary losses that would likely be passive losses and not allowed to be taken without passive income. However, there are also disadvantages, such as if a property that is combined as a single activity is sold at a loss, the related loss cannot be recognized until all the remaining activities that have been aggregated are sold.
If a taxpayer does not elect to aggregate rental activities, they must examine each of their rental properties separately to see whether they materially participated in each rental activity. Given the 500 hour and other material participation thresholds, this can prove virtually impossible if several properties are owned. Another elections allow certain taxpayers with the same proportionate interest in a trade or business and a rental activity (assuming the trade or business and rental activity are insubstantial to each other) to combine these activities in certain circumstances.
If a taxpayer does not meet the stringent rules of being classified as a real estate professional, they still may be able to offset up to $25,000 of losses from rental real estate against nonpassive income if they are considered to actively participate in the rental real estate. The active participation rules are generally much easier to meet than the material participation rules. To actively participate in a rental real estate activity pursuant to the Internal Revenue Code, a taxpayer simply needs to participate in a significant way, such as making management decisions or arranging for others to perform services. The taxpayer does not need to partake in regular, continuous, and substantial involvement in the activities to achieve active participation status. The $25,000 allowance begins to phase out for taxpayers with modified adjusted gross income over $100,000 ($50,000 if married filing separately) and is completely phased out when a taxpayer’s modified adjusted gross income reaches $150,000.
The above article merely summarizes the general rules as it relates to passive losses and real estate professionals. Careful planning with your tax professional should ensure that the best decisions are made with respect to the appropriate elections as well as meeting specific rules and requirements.