Under recently released IRS Revenue Procedure 2011-34, real estate professionals can now more easily make late elections to treat all interests in rental real estate as a single rental real estate activity. This election can help them retroactively meet material participation requirements and deduct losses, potentially generating an income tax refund. This article discusses the various requirements involved.
IRS makes it easier to deduct real estate activity losses
Under recently released IRS Revenue Procedure 2011-34, real estate professionals can now more easily make late elections to treat all interests in rental real estate as a single rental real estate activity. What does this mean to you? The election can help you retroactively meet material participation requirements and deduct losses, potentially generating an income tax refund.
Why it matters
The Internal Revenue Code (IRC) generally allows you to claim passive-activity losses only against income from other passive activities. If your passive losses exceed your passive income for the year, you can carry the losses forward until you either have enough passive income to absorb them or you dispose of the activity, in which case you’re generally allowed to deduct the losses against nonpassive income.
“Passive activity” is defined as any trade or business in which the taxpayer doesn’t participate on a regular, continuous and substantial basis (also known as “material participation”). Rental real estate activities are usually considered passive activities regardless of whether you materially participate — unless you qualify as a real estate professional. Then rental activities are treated as a trade or business, and losses from the activity aren’t considered passive, so you can deduct them against nonpassive income.
The stumbling block
A taxpayer qualifies as a real estate professional by satisfying two requirements. First, more than 50% of the personal services the taxpayer performs in trades or businesses must be performed in real property trades or businesses in which he or she materially participates. Second, during the tax year the taxpayer must perform more than 750 hours of services in real property trades or businesses in which he or she materially participates.
Under the IRC, a taxpayer’s interests in rental real estate generally will be treated as separate activities when determining whether the taxpayer materially participates in each rental real estate activity — unless he or she elects to treat all interests in rental real estate as a single rental real estate activity.
To make this election for a particular tax year, you must file a statement with specific information along with your income tax return. Taxpayers failing to make the election on their returns can seek an extension of up to six months by obtaining a letter ruling from the IRS.
However, this is a burdensome process. The taxpayer must, for example, file a “complete statement of facts and other information,” include copies of relevant documents, and provide an analysis of material facts and statements of authorities supporting and opposing the taxpayer’s position. The letter ruling request may also be subject to a user fee and a statute of limitations. After its review, the IRS may request additional information to make a determination. The process can take months from start to finish.
An easier way to make late elections effective
The IRS has now outlined special procedures, in lieu of the burdensome letter ruling procedure, for obtaining the tax benefit despite not making a timely election. To be eligible, a taxpayer must show the following:
- He or she failed to make the election solely because of failure to timely meet the election requirements.
- He or she filed consistent with having made an election on any return that would have been affected had the election been timely made — that is:a. The returns must have been filed “as if” the election had been made on a timely basis,
b. The taxpayer must have filed all required federal income tax returns consistent with the requested aggregation for all of the years under scrutiny, andc. Once the election is made, all future returns must be filed using aggregation unless the taxpayer no longer qualifies for aggregation or subsequently revokes the election.
- He or she timely filed each return that would have been affected by the election if it had ben timely made. (For these purposes, “timely” means that the return was filed within six months of the due date, excluding extensions.)
- There is reasonable cause for the failure to meet the requirements for the election (for example, reasonable reliance on the written advice of the IRS).
The procedure contains specific requirements for requesting relief for late elections. For example, you must attach a specific statement to an amended return for the most recent tax year, and the statement must contain a particular declaration, explain the reason for failing to file a timely election, and include certain representations.
Making the election
If you haven’t made the election to treat all real estate activities as one activity, check with your tax advisor. If you’re in need of retroactive relief, he or she can help ensure that you satisfy all of the various requirements to potentially receive an income tax refund.
Douglas Rutherford, CPA, CGMA
© 2012 Douglas Rutherford, CPA, CGMA. 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.
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