There are many of us who dabble in some rental real estate activity. The tax reporting rules surrounding rental real estate activity are many and a lot of times confusing.
The general rule is that income and losses from any rental activity are considered passive. Losses generated by such passive activities are allowed only to the extent that they can be offset by income from other passive activities. These suspended losses are not lost. These losses are carried forward to future years and can be offset against passive income generated in the future. In addition, the suspended losses are deductible in the year the activity generating the passive losses is disposed off.
There is however, an exception to the general rule. Activities of taxpayers that qualify as real estate professionals, escape the passive activity classification.
Advantages available to real estate professionals
Among the key advantages available to real estate professionals are:
- Can offset losses from rental real estate activities against other non-passive income
- Income from rental real estate is not self-employment income
- No Net Investment Income Tax of 3.8%
Having listed the advantages available to real estate professionals, we now need to look at the requirements to qualify as a real estate professional.
A taxpayer qualifies as a real estate professional for the year if both of the following requirements are met:
- More than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated
AND
- The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which they materially participated
Key here is material participation.
What is material participation?
There are seven tests to material participation. If any one of the seven tests is met, the taxpayer will be considered to be materially participate in that rental real estate activity.
- Participated in the activity for more than 500 hours
- Participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity
- Participated in the activity for more than 100 hours during the tax year, and participated at least as much as any other individual
- The activity is a significant participation activity, and the taxpayer participated in all significant participation activities for more than 500 hours
- Materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years
- Materially participated in a personal service activity for any 3 (whether or not consecutive) preceding the taxable year
- Participated in the activity on a regular, continuous, and substantial basis during the year
Material participation is determined separately for each property.
Married Filing Joint (MFJ) couple will qualify as real estate professional even if one spouse separately satisfies the real estate professional requirements.
Individuals working full time in a non-real estate activity will usually find it difficult to substantiate the real estate professional requirements.
Election to treat multiple rental real estate activities as one activity
A taxpayer can make an election under Section 469(c)(7) to treat all interests in rental real estate as a single rental real estate activity.
Taxpayers who engage in multiple rental real estate activities may find it difficult to establish material participation and thus qualify as a real estate professional if they do not make this election.
Example – John Do owns buildings A, B, C. He materially participates in A but does not materially participate in B &C. If John Do does not elect to treat the 3 buildings as one activity, he may not meet the material participation requirement for all 3 and may not qualify as real estate professional even if he meets the 750 hour requirement.
Final thoughts
Navigating the real estate professional rules can be very complex. Maintaining contemporaneous daily time reports, logs or similar documents to substantiate the hours worked in each rental real estate activity is very important.
In addition, consulting with a tax expert can help avoid costly mistakes. Reach out to us if you need help in tax planning related to rental real estate activity.
The tax professionals at Sol Schwartz & Associates have worked extensively with real estate owners and developers since our firm was founded in 1980. Let us know if you would like us to take a look at your situation. Tasneem Unwala, CPA can be reached at 210.384.8000 or tyu@ssacpa.com.
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