In a previous post we explained that rental losses are generally considered passive, and may not be deductible against non-passive income. Most individuals can only deduct up to $25,000 of rental losses against non-passive income, and that amount phases out for many taxpayers.
The IRS allows real estate professionals to treat rental losses as non-passive if the taxpayer materially participates in the rental activity. This means that they can deduct those rental losses against other types of income, like wages, interest and dividends, and business income. Real estate professionals are notsubject to the $25,000 limitation or to phaseouts.
What is a real estate professional?
For this purpose, an individual qualifies as a real estate professional if:
- More than 50% of the personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which he materially participates, and
- The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which he materially participates.
Tip: We’ll explain the rules for material participation in our next post.
What is a real property trade or business?
The tax code defines real property trade or business broadly to include the following activities related to real property:
- Development or redevelopment
- Construction
- Acquisition
- Conversion
- Rental
- Operation
- Management
- Leasing
- Brokerage
Let’s see how the rules apply with some examples:
Example 1
Sally is a lawyer. She has a law practice not related to real estate activities which took 950 hours of her time. She also has a business which acquires and develops real estate. She materially participates in this business and spent 825 hours in it in the current tax year.
Sally does not qualify as a real estate professional. Her 825 hours in real estate businesses is only 46% of her total personal services performed in all trades or businesses (950 + 825) during the year.
Tip: The real estate professional determination is made each year. Next year, Sally can qualify if her hours in real estate exceed the minimum of 750, and exceed her hours in her law practice.
Example 2
Jim is retired from his job as a teacher. He owns several rental houses, and spent about ten hours a week (500 total for the year) managing those properties.
Jim does not qualify as a real estate professional. Although 100% of his personal service hours are devoted to real estate trades or businesses, he does not meet the 750 minimum hour requirements.
Non-passive treatment applies to net rental income, too
Qualifying as a real estate professional is not necessarily a tax benefit.
The benefit occurs if you have net rental losses which would otherwise be passive losses. A real estate professional can use these losses to offset non-passive income such as wages.
However, a real estate professional must also treat net rental income as non-passive. Consider a taxpayer who has net passive losses from other sources, such as a limited partnership interest.
- If he is not a real estate professional, those losses could be deducted against his rental income in the current year.
- As a real estate professional, his rental income is non-passive, and he cannot deduct the passive losses – they are suspended and carried over to the next year.
Other considerations
- Hours spent managing short-term rental property (averaging less than seven days rental), such as a hotel or bed & breakfast, do not count toward the 750-hour test.
- You may need to elect to treat all rental real estate activities as a single activity in order to meet the material participation tests.
- For a husband and wife, at least one of the spouses must individually satisfy the 50% and 750-hour tests.
- Personal services performed as an employee are not treated as perfromed in a real estate trade or business unless the employee has more than 5% ownership (direct or indirect) in the employer.
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