Many who work in real estate also work a day job and do their real estate on the side. The IRS potentially considers all real estate activities a form of “passive income,” such that only so much can be deducted for losses.
For tax purposes, “real estate” means development, construction, acquisition, conversion, rentals, operation, management, or brokerage. All of these activities may be subject to passive activity loss rules.
The Default: Passive Activity Loss Rule
Under normal situations, if your real estate activity loses money in a year, you must carry that loss forward to a future year when the activity makes money. You cannot use it to offset your other income.
This is true of all so-called “passive” income and real estate activities. Also, real estate activities are handled separately. If you are a broker and you own a rental property, losses from one may be unable to offset income in the other. This limitation is called the “passive activity loss rule.”
Exception Number One: Active Participation
If you “actively participate” in your real estate activity, you can offset up to $25,000 of ordinary income using loses from any or all real estate activities. This limit phases out at incomes over $100,000 (single) or $50,000 (married filing separately).
Be careful: if your real estate activity shows losses year after year, your activity may be declared a “hobby” and all future deductions may be disallowed.
Also note that “participation” is subject to interpretation. The actual wording is “significant and bona fide.” If you are a significant and bona fide participant in the activity, you can take the $25,000 of deductions to offset other income.
Exception Number Two: The Real Estate Professional
If you are a so-called “real estate professional,” you will be allowed to use real estate losses to offset other income without limitation. There are three tests to pass.
First, you must work at least 750 hours a year on the activity. Second, more than half of all your hours worked in the year must be on the activity. Third, you must materially participate in the activity.
Note that working doesn’t count if you are an employee of a real estate company. This is intended for business owners. It will only count as an employee if you are at least a 5% owner of that company.
Note also the phrase “material participation.” This means you must pass a related requirement.
Material Participation in Real Estate
The intent of this rule is to make sure that you are actively working, as opposed to passively monitoring an investment and using real estate as a tax shield. The rules are extremely open to litigation, because they are vague and inter-related. You must meet ONE of the following seven requirements:
- You did basically all of the work on that activity, even after accounting for subcontractor time;
- You worked in the activity for 500 hours or more in the year;
- You participated in the activity for 100 hours or more in the year, and no one else on your team participated more than you;
- You participated in the activity for 100 hours or more in the year, and you participated in other real estate activities that totaled at least 500 hours;
- You passed this test for any five of the last ten tax years on the same activity;
- You personally did this same job for any three preceding years;
- You regularly, continuously, and substantially participated in the activity for at least 100 hours and you had neither a paid nor co-owner manager helping you.
Election to Combine
Each activity (each rental property, each flip) is considered separate for tax purposes. This means if you want to add up all your brokerage or rental activities, you must file an election with your return saying you want all your activities to be counted as one.
Be careful: you must still pass one of the “material participation” tests even after you combine. This can impact you if you were the primary contributor before, and after combination you are still under the 500-hour minimum but are no longer the primary contributor.
Real Estate Professionals Can Save a Lot
For part-time owners, landlords, brokers, and contractors who meet the requirements, documenting your status as a “real estate professional” for tax purposes can save you thousands, especially during years when your business is starting up and losing money.
This article is a summary of materials presented by Tax Materials, Inc and H&R Block, shared with us by member Mary Woods. Another good resource is NOLO’s “Every Landlord’s Tax Deduction Guide.” MassLandlords receives no compensation for referrals to any of these outlets. For full detail, view IRS Publication 925: Passive Activity and At-Risk Rules.
Disclaimer: Always consult with a certified public accountant before making any tax decisions.