Experienced Tax
Accountant –In addition to your regular business (which has nothing to do
with real estate), you have a number of rental real estate properties that are
throwing off losses that you'd like to deduct against your other income for tax
purposes. As you may be aware, the passive activity loss (PAL) rules would
normally make this impossible. Under those rules, losses from passive
activities—that is, activities in which you do not “materially participate”
(see below)—cannot be deducted against nonpassive activity income (such as
salary, professional fees, income from a business in which you do materially participate,
interest, or dividends); and credits from passive activities cannot be used to
reduce taxes on nonpassive activity income. For purposes of the PAL rules,
rental real estate activities are automatically treated as passive activities,
even if the owner “materially participates” in their management, operations,
etc. As a result, tax losses from rental realty can't be deducted against
nonpassive income.
One
important exception to this rule allows taxpayers to deduct up to $25,000 of
losses and credits from passive rental real estate activities against
nonpassive income, if they “actively participate” in those activities. (Active
participation requires a lesser degree of participation than “material
participation”). This exception phases out for taxpayers with adjusted gross
income over $100,000.
There's
another exception to the above rule that's even more potentially beneficial
than the $25,000 active participation rule I just mentioned. If you qualify as
a “real estate professional,” your rental real estate interests are not
automatically treated as passive activities. As a result, if you materially
participate in the rental real estate activity, the activity will not be
treated as passive, and you will be entitled to deduct losses from that activity
against nonpassive income. In addition, the amount of losses and credits
allowed under the $25,000 active participation rule is determined after any
recharacterization of rental real estate activities as nonpassive under the
rules discussed above. As a result, if you're a real estate professional, you
can deduct against nonpassive income not only losses and credits from rental
real estate that are nonpassive under the above rules, but up to $25,000 of
losses and credits from “active participation” rental real estate activities
that remain passive after application of those rules.
How do
you qualify as a real estate professional? First, you must materially
participate (see below) in a real estate business. The business of renting and
leasing realty is a real estate business. Second, more than 50% of the personal
services you perform in all businesses during the year must be performed in
real estate businesses in which you materially participate. Third, your
personal services in material participation real property businesses during the
year must amount to more than 750 hours. For these purposes, you can't count
any work you perform in your capacity as an investor.
In
determining whether you qualify as a real estate professional, each of your
rental real estate interests is treated as a separate activity—that is, as a
separate business—unless you make an election to treat all those interests as a
single activity. Because of this rule, if you have multiple rental properties
and you don't make the election, you must establish material participation for
each property separately, and must satisfy the more-than-50% test and the
750-hours test for each property separately in order to qualify as a real
estate professional with respect to that property—and qualifying for one
property wouldn't mean you qualify for any other property. Thus, if you don't
make the election, qualifying as a real estate professional for all your
properties becomes more difficult (and may become impossible) as the number of
properties increases. But if you do make the election, you only have to
establish material participation, and satisfy the more-than-50% test and the
750-hours test, for the combined properties as a whole.
You
don't have to work full-time in real estate to qualify as a real estate
professional. Even if you have another occupation, you can qualify if you
materially participate in a real estate business, and spend more time, and more
than 750 hours, on that business. (But remember, in this case, if you have
multiple properties, it may be difficult or impossible to qualify unless you
make the “single interest” election mentioned above.)
These
tests are applied annually. This means that you may qualify as a real estate
professional in some years but not in other years. As a result, the same real
estate activity may generate passive losses in some years and nonpassive losses
in other years.
If
you're a real estate professional, what more do you have to do to treat losses
from rental real estate as nonpassive? If you qualify as a real estate
professional, your rental real estate properties are not automatically treated
as passive. This doesn't mean that they are automatically treated as
nonpassive—it means that, if you materially participate (as explained below) in
the operation of a rental real estate property, then it will be treated as
nonpassive, and you may deduct losses from that property against other
nonpassive income.
But if
the real estate business that qualifies you as a real estate professional is
the renting or leasing of real property, as discussed above, you will already
have established that you materially participate in that business—because if
you don't, you can't qualify as a real estate professional on the basis of that
business (see above).
As I
mentioned above, if you have multiple properties, you may not be able to
qualify as a real estate professional unless you elect to treat all your rental
real estate interests as a single activity. If you make the election, it
applies both for purposes of qualifying you as a real estate professional, and
for all other purposes of the PAL rules. And, generally speaking, the election
is irrevocable. This means that you can't make the election in order to qualify
as a real estate professional, and then revoke it with respect to a particular
property later, when, for example, that property produces income, and you'd
like to use that income to absorb losses from another non-real-estate-related
passive activity. Making the election will also disqualify you from utilizing
the $25,000 active participation rule mentioned above, because that rule
applies only with respect to losses from rental real estate activities that are
passive, and the election will—presumably—work to make your rental real estate
properties nonpassive. (If making the election is the right course for you, I
can make sure that it is made in a timely and proper fashion.)
What's
material participation in an activity? Material participation in an activity
means involvement in the operations of the activity on a regular, continuous,
and substantial basis. If a taxpayer passes one of the following seven tests,
IRS accepts that as establishing material participation in an activity:
- participating in the activity for more than 500 hours in the tax year (the most frequently utilized test);
- participating in the activity if the taxpayer's participation is substantially all of the participation in that activity by any individuals (including non-owners);
- participating in the activity for more than 100 hours in the tax year, if nobody else (including nonowners) participated more;
- participating significantly in the activity, if participation in all “significant participation” activities for the tax year exceeds 500 hours (but this test isn't accepted for showing material participation in rental activities);
- having materially participated in the activity during any five of the ten tax years before the year at issue;
- with respect to personal service activities, having materially participated in the activity for any three years (not necessarily consecutive) before the year at issue;
- showing regular, continuous and substantial participation on the basis of all the relevant facts and circumstances, but only if more than 100 hours of participation during the tax year can be shown (and management services aren't taken into account for purposes of this test unless certain stringent requirements are satisfied).
The
extent of an individual's material participation in an activity may be
established by any reasonable means. But the most reliable means of showing
material participation consists of contemporaneously kept appointment books,
calendars, daily time reports, logs, or similar documents that provide a
detailed account of what the taxpayer did with respect to an activity, when he
or she did it, and how much time it took. Failure to substantiate material
participation is one of the most common ways of losing the right to treat
rental real estate activities as nonpassive.
Please
call me to schedule an in-depth review to determine whether you can qualify as
a real estate professional, and how you might use the above rules to your
advantage—or to discuss any other aspect of your business. I look forward to
hearing from you. Click this link to view our YouTube video http://youtu.be/EYJdQtbPZAI
Amare
Berhie
(651)
621-5777, (952) 583-9108, (612) 224-2476, (763) 269-5396
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