Most individual taxpayers who own rental real estate cannot deduct losses from their properties or their losses are limited.
The Internal Revenue Code (IRC) defines a passive activity as any trade or business of a taxpayer in which the taxpayer does not materially participate, and any rental activities of the taxpayer, regardless of the taxpayer’s level of participation.
Losses from passive activities are limited to income from passive activities. Any excess losses they are carried over or "suspended" to future years until there is additional passive income or the activity is sold.
Example: Taxpayer A is an IT professional who owns two rental properties generating $10k in losses and has a $175K salary. The rental
losses cannot be used to offset his salary, but are carried over to the next year.
There is an exception for those who qualify as a Real Estate Professional. If you qualify as a Real Estate Professional, the passive loss limitation does not apply.
Example: Real Estate Professional taxpayer has a construction business with net income of $180K and owns rental property with a loss of $25K. The rental losses can offset the net income from the construction business to reduce her income to $155K….saving A LOT of money in taxes.
To qualify as a Real Estate Professional you must meet two criteria:
• More than 50% of the personal services you perform must be in the real property trades or businesses in which you materially participate and
• You must spend more than 750 hours a year in real property trades or businesses in which you materially participate
A real property trade or business is defined as real estate property development, construction, reconstruction, acquisition, conversion, rental management, leasing or brokerage.
More than 50% Test
Generally, a full-time employee whose primary job is not in real property trade or business will not qualify as a real estate professional.
A typical full-time employee works 2,080 hours annually. To pass the more than 50% test, the taxpayer would have to work 1,021 hours annually in a real property trade or business.
750 Hour Requirement
You must provide real estate services for 750 hours. Hours worked as an employee in real property trades or business do not count, unless you own 5% or more of the company.
Defining Material Participation
In addition to meeting the above mentioned criteria, a Real Estate Professional must also materially participate in each activity.
Material participation requires a taxpayer to be involved in an activity on a regular, continuous and substantial basis and requires him to meet any one of seven tests detailed in the regulations. The most widespread is the safe harbor 500 hour test.
The 500 hour test requires a taxpayer to participate in an activity for 500 hours during the year. This test applies to each property owned by the Real Estate Professional. It is possible that one property may qualify for material participation and another one will not, unless grouping is elected.
With grouping, a taxpayer can treat one or more trade or business activities, or rental activities, as a single activity. Grouping makes it easier for all activities to meet material participation rules and qualify losses as nonpassive. These losses can be used to lower income from wages, interest, business, etc. as illustrated previously.