Author: Paul Heckman, CPA
Generally, losses incurred from rental real estate properties are considered “passive” to most property owners. This can be frustrating to many individuals who feel as though they are continually incurring expenses, but not realizing the benefits of the associated losses. Unfortunately, if a property owner does not have passive income to offset with passive losses, the losses are not deductible in the current tax year and must be carried forward for use in future tax years in the form of passive activity losses. The passive activity losses will continue to carry forward until passive income is available to offset or until the property is disposed of.
Many property owners may not realize that there are two aspects of the Internal Revenue Code that can help mitigate this issue. The first is through an exception referred to as “active participation,” which allows property owners to deduct up to $25,000 of passive activity losses. To qualify as an active participant, a property owner must:
1. Own at least 10 percent of the property, and
2. Make management decisions, such as acquiring and approving tenants, coordinating repairs or arranging for another party to make these management decisions.
The $25,000 deduction may be limited if the property owners adjusted gross income exceeds certain thresholds. For married taxpayers filing jointly, the $25,000 passive activity loss deduction will begin to phase out for AGIs of $100,000 or higher. If the married taxpayers' AGI is higher than $150,000, the passive loss deduction is completely phased out. Additionally, the $25,000 passive loss deduction is only allowable to the extent that the property owner has generated $25,000 of passive activity losses.
The second exception is for property owners who can qualify as “materially participating real estate professionals.” A real estate professional is someone who:
1. Spends more than 50 percent of all personal services provided during the tax year in real property trades or businesses in which they materially participated, and
2. Performed more than 750 hours of services during the year in real property trades or business in which they materially participated.
There are seven tests used to determine material participation although only one of the seven must be met in order to qualify as materially participating. Some of these tests include:
1. More than 500 hours test: The taxpayer must participate in the activity for more than 500 hours during the year.
2. Substantially all participation test: The taxpayer's participation in the activity must be substantially all of the participation in that activity by all individuals for the year.
3. More than 100 hours test: The taxpayer participated more than 100 hours during the year and no other individual participated more than the taxpayer.
4. Significant participation test: The taxpayer must participate in an activity for more than 100 hours during the year and the sum of significant participation activities in which the taxpayer participates must exceed 500 hours for the year. This is helpful if there are multiple activities in which the owner is involved.
It is important to note that the IRS has been known to take an aggressive stance on taxpayers who consider themselves a materially participating real estate professional. It is vital that property owners thoroughly document time spent and activities performed throughout the tax year.
Perhaps the easiest way to meet these requirements is for a property owner to aggregate all interests in real estate activities as a single interest; however, once the aggregation election is made, it is irrevocable unless there is a material change in the taxpayer's circumstances.
There are a variety of ways in which property owners can minimize their tax burden. The exceptions discussed above may often be overlooked due to their complex requirements; nevertheless, they should not be ignored, as they can offer money-saving opportunities to those who are able to qualify.
A. Paul Heckman has more than 12 years' experience in public accounting providing tax consulting and compliance services. He can be reached at firstname.lastname@example.org.
Source: Inside Business – The Hampton Roads Business Journal
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.