By Lauren E. Barton, CPA
Generally, losses incurred from rental real estate properties are usually considered “passive” to most taxpayers. This can be frustrating to many individuals who feel like they are constantly incurring expenses, but never reaping the benefit of taking the losses. If there is no other passive income to offset the losses, then the losses are not deductible in that year and must be carried forward to future tax years in the form of Passive Activity Losses. While unfortunately this is the case for many taxpayers, there are some ways to mitigate this situation.
There are two other categories that a taxpayer can fall into. They are “active participation” and “materially participating real estate professional.”
If it is determined that you have actively participated in a rental real estate activity, you are allowed to deduct up to a $25,000 ordinary loss. In order to be considered an active participant in a rental real estate investment you must meet the following criteria:
- You own at least 10% of the rental property
- You make management decisions, or arrange for another party to make these decisions (e.g. acquiring tenants, coordinating repairs and other expenses.)
- Your Adjusted Gross Income (AGI) is less than $150,000. If your AGI is $100,000, then you will get the full $25,000 loss. For any amount over that, the $25,000 loss begins to be proportionately phased-out; at an AGI of $150,000 or more, the loss is completely phased-out.
Keep in mind that for both “passive” and “active” investments, in the year in which you sell the property, you will get to deduct all of the accumulated passive activity losses that have been suspended.
Materially Participating Real Estate Professional
A Real Estate Professional is a taxpayer who meets the following requirements:
- More than 50% of all trade or business services they provide during the tax year are performed in real property trade or business in which they materially participated
- They performed more than 750 hours of services during the tax year in real property trades or businesses in which they materially participated (See 7 steps below for what constitutes material participation)
The IRS has been known to take an aggressive stance against taxpayers who consider themselves a Materially Participating Real Estate Professional. It is extremely important that you document and keep a log of the hours you spend and activities you perform. Without having proper documentation, if you were to get audited, the IRS would say that you do not meet the criteria to be a Real Estate Professional. The rules for “materially participating real estate professional” are very stringent. Material participation occurs when the taxpayer has a regular, continuous, and substantial role. However, it does not end there. There are seven tests to determine material participation and we will briefly highlight them. Only one of the tests must be met to be considered qualified.
- More than 500 Hours Test: The taxpayer must participate in the activity for more than 500 hours during the year.
- Substantially All Participation Test: The taxpayer’s participation must be substantially all of the participation by all individuals for the year.
- More than 100 Hours Test: The taxpayer participated more than 100 hours during the year, and no other individual participated more than the taxpayer.
- Significant Participation Test: The taxpayer must participate in an activity for more than 100 hours during the year and their annual participation in all significant participation activities totals to more than 500 hours. This is helpful is there are multiple activities you are involved in.
One option taxpayers have in order to meet the qualifications of material participation is to aggregate properties. This is when you can treat all interests in real estate as one activity in order to meet the substance and hour tests.
If you think you might meet the definitions of a “materially participating real estate professional”, please consult an advisor at Keiter, as these IRS guidelines are very complicated and can vary depending on your situation. We will be able to provide more details for your specific circumstance.
Now is a better time than ever to look into these rules if you are involved in any sort of real estate activities to see if you could potentially qualify as something other than a passive real estate investor. Beginning in 2013, the new 3.8% Medicare Surtax will apply to all investment income, including real estate properties. Stay tuned for another publication highlighting this new tax and how it will affect you.
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.