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The passive-activity loss rules can significantly limit the tax
benefits of owning rental properties, but the IRS provides a
potentially valuable exception for so-called “real estate
professionals.” You may be familiar with some of the
better-known tests for determining whether you qualify, but you
could qualify under one of the lesser known tests. If you think you
are eligible, regardless of under which test, you also need to
understand how the IRS will make the determination.
THE TAX BREAKS FOR REAL ESTATE PROFESSIONALS
Under the Internal Revenue Code (IRC), taxpayers generally are
prohibited from deducting passive-activity losses against
non-passive sources of income, such as wages. Passive-activity
losses can be used only to offset passive-activity income, with any
excess losses in a tax year carried forward to be applied against
future passive-activity income.
The IRC defines “passive activity” as any trade or
business in which the taxpayer does not participate on a regular,
continuous and substantial basis — what is known as
“material participation.” A passive activity loss is the
excess of the taxpayer’s deductions from all passive activities
for the tax year over the gross income from those activities.
The IRS typically considers rental real estate activities to be
passive, regardless of whether the taxpayer materially
participates. But it allows real estate professionals to deduct
their passive-activity losses against non-passive income.
Real estate professional status also can reduce your liability
for the 3.8% net investment income tax (NIIT) on passive income.
You must, however, engage in a trade or business related to the
rental real estate activities; the rental activities cannot be
merely incidental to a non-rental trade or business.
Specifically, net rental income may be excluded from the
calculation of NIIT if:
You are a real estate professional;
The rental activity rises to the level of a trade or business;
and/or
You materially participate in the trade or business.
In these circumstances, rental income is considered to come from
conducting business, not an investment.
THE MATERIAL PARTICIPATION REQUIREMENTS
You qualify as a real estate professional if you satisfy two
requirements:
More than 50% of the personal services you perform in trades or
businesses are performed in real property trades or businesses in
which you materially participate; and
You perform more than 750 hours of services in real property
trades or businesses in which you materially
participate.
If you file a joint tax return with your spouse, you can meet
the requirements if only one of you separately meets the
requirements.
THE MATERIAL PARTICIPATION TESTS
Federal tax regulations identify several tests for determining
whether a taxpayer has materially participated in an activity for a
taxable year (the determination is made on a year-by-basis). Many
rental property owners know they can qualify by:
Working in the activity for more than 500 hours during the year
(spousal hours are included but not those of children);
Doing “substantially all” of work; or
Working for more than 100 hours during the year, and no other
individual works more hours (including non-owners and
employees).
You may not know, though, that you could still qualify as a real
estate professional even if you fail to satisfy these tests. For
example, you might qualify if you materially participated in the
activity in any five of the previous ten years (consecutive or
not).
Finally, even if you do not meet any of the tests above, you can
establish your material participation in the rental real estate
activities based on all of the facts and circumstances. Note that
this test applies only if you work at least 100 hours in the
activity, and no one spends more hours managing the activity or is
compensated for managing the activity. In other words, you cannot
rely on this test if you have paid management for your
property.
Related Read: Hiring a Property Manager? Consider Lodging as a
Fringe Benefit
MAKING YOUR CASE
Federal tax regulations provide that taxpayers can establish the
extent of their participation in rental real estate activities
“by any reasonable means.” That can include the
identification of services performed over a time period and the
approximate number of hours spent on those services during the
period.
You can base these figures on documents such as appointment
books, calendars or narrative summaries. While contemporaneous
daily time reports, logs or the like are not required, they are
highly advisable. Some type of detailed documentation of your
rental activity hours is essential. Tax courts have not looked
favorably on estimates based on records assembled some time after
the activities occurred.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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