Tax Considerations for Real Estate Investors Mini Series: Can I Deduct My Losses?

Passive Loss Limitations and the Real Estate Professional Rules

Many taxpayers own business real estate, whether directly or through ownership in a partnership or a limited liability company. It is common for real estate investments to generate losses, especially in the initial years of operation, due to depreciation and interest deductions. Unfortunately, with few exceptions, individual taxpayers with income and losses from rental properties are subject to the passive loss limitation rules. Under these rules, the deduction for net loss from rental real estate properties is limited to $25,000 or less, depending on the taxpayer’s modified Adjusted Gross Income (AGI), the taxpayer’s role in the rental business (active vs. passive) and whether net passive income from other activities is present.

However, if a taxpayer can qualify as a Real Estate Professional, the passive loss limitations do not apply. Taxpayers involved in a real property trade or business, such as construction or real estate management and sales, may qualify for one with respect to one or more real estate rental activities. On the contrary, a real estate investor that is employed full-time earning a W-2 wage or who is self-employed in an industry completely unrelated to real estate, would have a more difficult time overcoming the high standard of being considered a Real Estate Professional (losses are fully deductible against other income for those activities in which the taxpayer is considered a Real Estate Professional).

To qualify as a Real Estate Professional and overcome the presumption that all rental activities are passive, there are two quantitative tests under IRC. Section 469(c)(7)(B) that the taxpayer must meet:

1. More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and,
2. The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

This is not as simple as it might sound, so a careful analysis of a taxpayer’s activities is required.

Steps to Qualify as a Real Estate Professional

The following steps should be followed to determine whether a taxpayer first qualifies as a Real Estate Professional, and if so, whether the taxpayer’s rental activities are nonpassive:

Step 1: Identify and group the taxpayer’s real property trades or businesses.

Step 2: Identify the taxpayer’s real property trades or businesses in which the taxpayer materially participates.

Step 3: Total the hours of participation in those real property trades or businesses in which the taxpayer materially participates. (If the taxpayer is married, only count the hours from the spouse seeking to qualify as a Real Estate Professional.)

Step 4: Apply the hours from Step 3 to the two quantitative tests of Sec. 469(c)(7)(B) above: do the hours exceed 750, and are more than 50 percent of the taxpayer’s personal services performed in real property trades or businesses in which the taxpayer materially participates?

Step 5: A taxpayer who passes both tests in Step 4 is a qualifying Real Estate Professional.

The qualifying professional must next establish material participation in his or her rental activities.

Material participation, defined below, is generally applied to each separate rental activity. If one of the tests is met, that rental activity is nonpassive. However, if the taxpayer does not materially participate in a rental activity, that activity is passive, despite qualifying as a Real Estate Professional.

To overcome this hurdle, a taxpayer can elect to aggregate “all” of his or her rental activities to meet the material participation requirement. If the taxpayer materially participates in the combined activities, then all the aggregated rental activities are nonpassive under the real estate professional rules.

Material Participation

To be considered a material participant in a real property trade or business, the taxpayer must pass one of seven specific tests. In general, material participation in any trade or business is measured by the standard of “regular, continuous, and substantial” participation. A taxpayer need only meet one of the seven tests.

1. The individual participates in the activity for more than 500 hours during the tax year;
2. The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
3. The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
5. The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

There are potential downsides to electing to be a Real Estate Professional, as the election is not revocable unless there is a significant change in facts and circumstances. Additionally, if passive losses have carried forward up to the point of the election to become a Real Estate Professional, these losses are suspended until disposition of the activity. Lastly, depending on the facts and circumstances, a taxpayer could be subject to self-employment tax on their income from nonrental real estate activities.

These rules are complex and taxpayers should also consider how the new tax reform laws might further impact their tax situation. Contact our Sikich real estate tax experts to determine if the real estate professional rules can benefit you. And be on the lookout for upcoming alerts concerning tax reform’s impact on real estate, as our experts continue to monitor IRS guidance and relevant news. Future articles can be found in our ongoing Tax Considerations for Real Estate Investors series.