written by Chelsey Dollarhide
When owning a rental property that either has, or will, show a loss, it is important to determine whether that loss is fully or conditionally deductible on your income tax return in order to make the most informed and appropriate tax planning decisions.
Ordinarily, rental activities, including rental real estate, are a passive activity under tax code. If an activity is passive, losses from the activity are treated as passive activity losses and cannot be deducted against nonpassive income, such as wages.
However, there is an exception to the rule that allows a taxpayer to consider the real estate activity nonpassive (and therefore allows the deduction to be taken against nonpassive income.) This exception is for a real estate professional who materially participates in the real estate activity.
In order to be considered a real estate professional, you must meet two specific criteria. You must both “perform” enough hours in all real estate trades or businesses and “materially participate” in the particular activity.
In order to meet the criteria for a real estate professional, the IRS requires that the taxpayer:
- Perform more than half of his or her personal services in real property trades or businesses in which the individual materially participates
- Performs 750+ hours of services in real property trades or businesses in which the individual materially participates.
A taxpayer materially participates in an activity if he or she participates in the activity for more than 500 hours during the year. This 500-hour threshold has to be met separately for each individual activity.
If both of these requirements are met, the taxpayer can use real estate losses to offset other income on their tax return.
In the following example, the IRS looked at a taxpayer who owned two rental real estate properties and who also owned a real property development business. The taxpayer performed more than 750 total hours of personal services in all of the real estate activities. The rentals and the development business were a combined real property trade or business.
The question arose whether the 750-hour performance test could only apply to an individual activity (such as the separate real estate rental properties) that met the 500-hour material participation test.
The IRS concluded that this was not necessary. Since the taxpayer spent more than 500 hours in this combined real property business, time spent in each of these activities (the rentals and the property development) could be counted toward the 750-hour test. Thus, the taxpayer satisfied the requirements for being a real estate professional.
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However, the two rental properties were separate activities. So, before the taxpayer could deduct losses from either rental activity, it was necessary to determine whether the taxpayer materially participated in the individual activity. An activity is passive unless the taxpayer satisfies the 500-hour test for that activity, even if the taxpayer is a real estate professional.
If you have any questions about passive activity losses, please contact The Whitlock Co. to request a consultation. We serve Kansas City, Springfield, and Joplin in Missouri.