If a person owns rental properties, there’s a good chance at least one of them will generate a loss during ownership. But the passive activity loss (PAL) rules can make it difficult to deduct those losses. If rental real estate is a significant activity, it pays to review the situation to determine whether one meets the IRS’s definition of “real estate professional.” This article explains some of the circumstances in which one may qualify and how it might be possible to convert passive losses into non-passive losses, creating substantial tax benefits.
As you may know, our analysis software has the most comprehensive income tax module available. Simply select from drop-down menus to make your choices which include income tax rates, like-kind exchange, IRA, Roth & 401(k) ownership, US tax system, Canadian tax system, personal property, etc. One option relates to passive activities. I am often asked to explain what the tax passive activity losses rules are and how they affect real estate analysis.
Generally speaking, a great real estate investment will not produce tax losses even though you are able to deduct items such as tax depreciation. Essentially, if a property produces a tax loss, it will most likely have produced an economic loss… not a good thing. However, there are times when losses are expected such as during a lease-up or when you are purchasing a badly-managed property.
Even though you may run analysis on properties before purchase, there’s a good chance that at least one of your properties may generate a tax loss at some point during ownership. But the passive activity loss (PAL) rules can make it difficult to deduct those losses.
In such a situation, it pays to determine whether you meet the IRS’s definition of a “real estate professional.” If you qualify, you may be able to convert passive losses into non-passive losses, creating substantial tax benefits.
A passive activity primer
The PAL rules prohibit taxpayers from deducting losses generated by “passive” business activities — such as certain limited partnerships (for example, one that holds real estate) — from wages, interest, dividends or other “non-passive” income. Disallowed losses may be carried forward and deducted against passive income in later years or recovered when the passive business activity is sold.
A passive activity is a trade or business in which you don’t “materially participate.” “Participation” is generally any work done by an individual with respect to the activity that the individual owns an interest in. “Participation” doesn’t include work that isn’t customarily done by an owner if one of the principal purposes for performing the work is to avoid the passive loss rules.
“Material” means “regular, continuous and substantial,” but that definition doesn’t provide much guidance. Fortunately, IRS regulations establish several objective tests you can apply to determine whether an activity qualifies. Your participation in an activity is material if any one of the following is true during a tax year:
- You participate in the activity for at least 500 hours.
- Your participation constitutes substantially all of the participation in the activity by all persons (including non-owners) — in other words, it’s a one-person operation.
- You participate in the activity for at least 100 hours and no other person (including non-owners) participates more than you.
- You participate in the activity for at least 100 hours and your total participation in “100 hour” activities totals more than 500 hours.
- You materially participated in the activity for any five of the preceding 10 tax years (or any three previous tax years for a personal service activity).
Even if you don’t satisfy one of these tests, you can meet the material participation requirement if, based on all the facts and circumstances, you participate in an activity on a regular, continuous and substantial basis. And married couples can combine their hours. But relying on this subjective test can be risky.
The catch for real estate
There’s an added catch when it comes to real estate: The PAL rules treat income from rental real estate as passive, no matter how many hours you devote to it, unless you qualify as a “real estate professional.” (See “Going pro” below.)
There’s a limited exception that allows you to deduct up to $25,000 in losses from rental real estate in which you “actively” participate, but the deduction is phased out beginning when adjusted gross income (AGI), with certain adjustments, reaches $100,000 and eliminated when it tops $150,000 for most taxpayers.
As mentioned above, you may be able to avoid the PAL limitations and deduct rental real estate losses from non-passive income if you’re a real estate professional. To qualify, you must spend more than half of your working hours and more than 750 hours during the year on real estate businesses in which you materially participate.
Activities you perform as an employee don’t count toward these participation requirements unless you own at least 5% of the business. Eligible businesses include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. Unlike the material participation requirements, you and your spouse can’t combine your hours; one of you must individually qualify as a real estate professional.
Even if you’re a real estate professional, you must still materially participate in a rental activity before you can deduct losses against non-passive income. This can be a problem if you’re involved with several properties.
Suppose, for example, that you own 10 rental buildings and devote 80 hours per year per building to managing them, for a total of 800 hours per year. You also have two full-time employees who help manage the buildings. Assuming the 800 hours you spent in the last year constitutes more than half of your working time, you would qualify as a real estate professional. But because you spent less than 100 hours on each building, you don’t meet the material participation requirements.
You can get around this restriction — and convert your rental losses from passive to non-passive — by electing on your tax return to treat all of your rental properties as a single activity. But once you make this election, you must stick with it. So, for instance, if your rental activities become profitable in the future, you won’t be able to offset your net rental income with passive losses from other activities.
Make the most of your losses
If you have rental real estate losses, find out from your tax advisor whether you can treat them as non-passive losses. If you can, the ability to deduct rental losses from your wages or other non-passive income can translate into significant tax savings.
© 2011 Douglas Rutherford, CPA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA. Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.