Qualifying as a Real Estate Professional
By Rachel Lawent, Senior, Tax & Business Services
Income or loss derived from the rental of real estate is generally considered a passive activity. One of the main consequences of a rental activity being treated as a passive activity for tax purposes is that losses can only be deducted against passive income. If there is no, or insufficient, passive income in a year of passive loss to fully offset the loss, the passive losses are carried forward indefinitely until there is passive income to offset them.
The default assumption related to rental activities is that such income is passive. This means that passive income can be subject to the Net Investment Income Tax. The Net Investment Income Tax is an additional 3.8% tax on the lesser of net investment income or the excess of a taxpayer’s modified adjusted gross income over a certain threshold ($250,000 if married filing jointly; $200,000 if filing single). Passive income, among other types of income, is considered to be net investment income. (Note: This treatment may be modified under the President’s recent proposals).
It is possible for rental income/loss to be considered non-passive instead of passive if the taxpayer meets two requirements:
- First, the taxpayer must qualify as a real estate professional (which itself consists of two requirements, discussed below).
- Second, the taxpayer must materially participate in the rental activity. The definition of material participation includes seven different quantitative tests, and as long as one of these tests is satisfied, the taxpayer is considered to be materially participating in the activity. For example, the first test is that the taxpayer spend more than 500 hours on the activity during the tax year. Thus, it is possible that a taxpayer with more than one rental property could have materially participated in some activities but not others. If that’s the case, a taxpayer who qualifies as a real estate professional would only be able to treat as non-passive those rental activities he or she materially participates in. Any other rental activities would still be passive.
The requirements for qualifying as a real estate professional are as follows:
(1) More than half of the personal services provided by the taxpayer during the year were in real property trades or businesses in which the taxpayer materially participates; and
(2) The total hours performed during the year in real property trades or businesses in which the taxpayer materially participates exceeds 750 hours.
The implication of these requirements is that real estate needs to be the taxpayer’s main area of work in order for the taxpayer to qualify as a real estate professional. It is difficult to qualify as a real estate professional if you have a full-time job in an area other than real estate.
A taxpayer who determines that it would be beneficial to qualify as a real estate professional and who has multiple rental businesses may find it helpful or essential to make an election to aggregate his or her rental activities. If this election is made, all of the taxpayer’s rental activities are treated as one activity for the purposes of determining material participation. Thus, if using test #1, as mentioned above, the taxpayer must spend more than 500 hours during the year on the aggregated rental activity instead of on each individual activity. Aggregation is not automatic. A qualifying real estate professional wishing to aggregate rental activities must attach a statement to his or her tax return formally making the election. Once made, the election is binding for all future years for which the taxpayer qualifies as a real estate professional. The election can be revoked, but only in a year when there is a substantial change to the taxpayer’s facts and circumstances, and must be done by attaching a statement to the tax return for the year of the revocation.
For those who meet the requirements, qualifying as a real estate professional can provide a more favorable tax treatment of real estate income and losses. If you have any questions about qualifying as a real estate professional, please contact your Marcum tax professional for assistance.