Qualifying for passive activity loss as a real estate professional

Real estate investors who qualify are permitted to deduct their rental real estate losses against other income sources (e.g., commissions, wages, and so forth). A real estate professional (salespersons and brokers) can make rental losses fully deductible if the person meets the following criteria:

  1. He/she works at least 750 hours in the year as a real estate agent, property manager, or other listed real estate occupation. Real estate professionals must be prepared to prove to the IRS that they are really real estate professionals.
  2. For part-time real estate professionals, it is allowable to work in another non-real estate-related job if more than 50 percent of the total work hours are spent as a real estate agent, property manager, or other listed real estate occupation.
  3. Rental real estate must be owned by the real estate professional.

In the case of a joint return, note that only one spouse needs to be a real estate professional if either spouse satisfies the requirements.

Basic passive loss rules:

  • A rental activity without regard to whether or to what extent the taxpayer participates in such activity (therefore, a rental activity is treated as a passive activity, regardless of the level of the taxpayer’s participation)
  • A trade or business activity in which the taxpayer does not materially participate for the taxable year

Be prepared to keep detailed records

If audited by the IRS, the taxpayer will need to verify that they have spent enough hours in a real estate profession and enough hours taking care of their rental properties. The taxpayer will need appointment books, diaries, calendars, logs, etc. A professional will to answer the following questions to show that they materially participate in the following rental activities:

  • Who monitors the rentals?
  • Who collects the rent?
  • Who does the repairs?
  • Is there a real estate agent or manager or employee responsible for any of the rentals?
  • Is anyone besides the taxpayer involved with managing or overseeing any of the properties?
  • Does a relative or friend manage or monitor the property for free?
  • Does a tenant receive free or reduced rent for managing the rentals or for caring for the properties?

Note that total amount of the taxpayer’s management contribution is ignored if the involvement only consists of:

  • Studying and reviewing financial statements
  • Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use
  • Monitoring the finances or operations of the activity in a non-managerial capacity

Material participation is determined by qualifying for any of these tests

  1. Real estate professionals who spend more than 500 hours in their rental activity may qualify for relief from the new 3.8% tax on net investment income imposed by the Affordable Care Act.
  2. When an individual’s participation in the activity for the taxable year constitutes substantially all (e.g., more than 70 percent of the total business hours for the year are performed by the owner) of the participation in such activity (including nonowner employees) for such year, the individual is materially participating in the activity.
  3. An individual participating in the activity for more than 100 hours during the taxable year is materially participating so long as such individual’s participation in the activity for the taxable year is not less than that of any other individual (including nonowner employees) for such year.

Each rental is considered a separate activity. For these reasons, most real estate professionals should aggregate all rentals into one activity. It is important to remember that the aggregation option permits the taxpayer to meet the material participation test after cumulatively materially participating (e.g., working 100 hours or 500 hours) in all the real estate rentals. Without the aggregation option, the investor would be required to materially participate (i.e., work 100 hours or 500 hours) in each activity.

Any participation by one spouse is attributed to the other spouse, even if no joint return is filed and/or the participating spouse has no ownership interest in the activity. In effect, material participant status of both spouses is determined as though the two spouses were one individual. The personal services of an employee are not counted unless the employee is also at least a 5 percent owner (i.e., owns more than 5 percent of the outstanding stock or more than 5 percent of the total combined voting power).

Statement is required for new groupings

A taxpayer must file a written statement with the original income tax return for the first taxable year in which two or more trade, business, or rental activities are originally grouped as a single activity. This statement must identify the names, addresses, and employer identification numbers, if applicable, for the trade, business, or rental activities being grouped as a single activity. In addition, any statement reporting a new grouping of two or more trade, business, or rental activities as a single activity must contain a declaration that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss.

Real property trade or business means real property involved in one of four general activities:

  • Development, redevelopment, construction, reconstruction, acquisition, or conversion
  • Rental
  • Operation, management, or leasing
  • Brokerage trade or business

Rental activity is passive activity regardless of material participation

However, the IRS has identified the following activities as non-passive:

  • The average period of customer use is seven days or less. Those renting vacation homes may fall under this “business, not rental” exception.
  • The average period of customer use is 30 days or less and significant personal services are provided by or on behalf of the owner of the property. For example, significant personal services include maid or linen services. Certain services are specifically excluded, such as cleaning public entrances, stairways, or lobbies and collecting and removing trash.
  • Extraordinary personal services are provided by or on behalf of the owner of the property. For example, a hospital room falls under this exception.
  • The rental of such property is treated as incidental to a nonrental activity of the taxpayer. This exception applies to property rented to employees at the employer’s convenience, investment property that is held primarily for appreciation, and the gross rental income from the property is less than 2 percent of the lesser of the unadjusted basis or the fair market value of such property.
  • The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers. For example, a golf course falls under this exception.
  • The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest.