Real Estate Losses for “Real Estate Professionals”
Senior Tax Accountant
Real Estate Losses for “Real Estate Professionals”Imagine the following scenario: A High Net-Worth doctor earns $400k per year. After saving for a few years, they put 10% down on a $2 million apartment building as a rental investment. After having a cost-segregation study done, his bonus depreciation allows him a taxable loss of $400K on the rental property, wiping out all his taxable income for the year. Sounds too good to be true? It likely is.
The Tax Reform Act of 1986 introduced Tax Code Sec. 469 – “Passive activity losses and credits limited”, which limits the application of passive losses to reduce taxable income. Since its enactment, passive losses can only be used to reduce passive income, with the excess being carried forward to a tax year with additional passive income or until the disposition (sale) of the activity. Sec 469(c)(1) defines “passive activity” as any trade or business activity in which the taxpayer does not materially participate. Sec 469(c)(2) then specifically includes any rental activity not by a “real estate professional” as a passive activity.
Therefore, to have active losses in rental real estate, two hurdles must be crossed:
-The taxpayer must materially participate in the activity of the rental to avoid the 469(c)(1) limitation.
-The taxpayer must be considered a real estate professional by the IRS to avoid the 469(c)(2) limitation.
Real Estate Professional (As defined by the IRS)
The IRS requires the taxpayer to meet both of these two criteria to be considered a Real Estate Professional:
-More than one-half of all services performed in a trade or business were performed in real property businesses.
-More than 750 hours were performed in real property businesses.
The first of these tests disqualifies the majority of taxpayers because the IRS includes a taxpayer’s regular employment in this calculation. Meaning that a full-time employee typically spends 2,000 hours a year at their job, and to surpass that amount while concurrently managing rental properties is near impossible. In our scenario, this would most likely prevent the doctor from taking their rental losses as an offset to ordinary, non-passive income.
Material Participation (As defined by the IRS)
The taxpayer is considered materially participating in an activity provided they meet any one of the following seven tests:
-The taxpayer participated in the activity for more than 500 hours in the tax year.
-The taxpayer participation was substantially all of the participation in the activity out of all individuals in the tax year.
-The taxpayer participated in the activity for more than 100 hours in the tax year and participated more than anyone else.
-The taxpayer materially participated in the activity for five out of the previous ten years.
-The activity is a personal service activity, and the Taxpayer materially participated in the activity for any three years preceding the tax year. Personal services include performance in the fields of health, law, engineering, accounting, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
-Based on all facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.
-The activity is a “significant participation” activity, and the taxpayer’s participation in all “significant participation” activities combined is more than 500 hours for the tax year. (A “significant participation” activity is one where significant capital is not required to participate).
When it comes to material participation, each rental property must meet one of the above tests. However, a real estate professional can elect to aggregate all of their rental activities under a single activity.
Special Allowances of Losses
If the taxpayer does not pass both the hurdles to make their rental losses active, they may still qualify to realize up to $25,000 of passive real estate losses through “active participation”. This is a lower threshold than “material participation”, and only requires that the taxpayer “participate in making management decisions or arrange for others to provide services (such as repairs) in a significant and bona fide sense”. All but the most passive of real estate investors should have no issue passing this test.
Additionally, there is also an income phase-out to take advantage of this allowance equal to 50% of every dollar above $100,000 of modified adjusted gross income (MAGI). MAGI in this sense is your Adjusted Gross Income with the following additions:
- Publicly Traded Partnership Losses
- Passive Activity Income or Loss from Form 8582
- Deductible IRA Contributions
- Deductible Self-Employment Taxes
- Deductible Student Interest
- Taxable Social Security Income
- A few other Schedule 1 Adjustments
This entire allowance is phased out at a MAGI of $150,000. The thresholds are not reduced for Single Taxpayers but are for Married Filing Separately Taxpayers.
-To take full advantage of losses generated by rental real estate, a taxpayer must both be considered a Real Estate Professional (R.E.P.) by the IRS and materially participate in the rental activity.
-To be considered a R.E.P. a taxpayer must devote the majority of his services to real estate activities; at least 750 hours.
-To be considered materially participating, a taxpayer must meet one of the above-listed qualifications.
-There is a special allowance for passive real estate losses of up to $25,000 given a taxpayer’s recalculated MAGI.
Please consult with your investment adviser and tax professional to see what you qualify for.