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.
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.