Under the passive activities loss rules (PAL) – that is, activities in which you do not “materially participate”, tax losses from rental real estate activities cannot be deducted against non-passive activity income (such as salary, professional fees, income from a business in which you materially participate, interest, or dividends). For purposes of the PAL rules, rental real estate activities are automatically treated as passive activities, even if the owner materially participates in the management and operations.
One important exception to this rule allows taxpayers to deduct up to $25,000 of losses from passive rental real estate activities against non-passive income, if they “actively participate” in those activities. Active participation requires a lesser degree of participation than “material participation.” This exception is of little benefit however because it begins to phase out for taxpayers with adjusted gross income over $100,000, and is fully lost at $150,000 of adjusted gross income.
There’s another exception to the above rule that’s more beneficial than the $25,000 active participation rule. If you qualify as a “real estate professional,” your rental real estate interests are not automatically treated as passive activities. As a result, if you materially participate in the rental real estate activity, the activity will not be treated as passive, and you will be entitled to deduct losses from that activity against non-passive income. The tax implications for qualifying real estate professionals (QREP) is discussed further on our website.
In determining whether you qualify as a QREP, each of your rental real estate interests is treated as a separate activity unless you make an election to treat all those interests as a single activity (“Grouping Election”). Because of this rule, if you have multiple rental properties and you don’t make the Grouping Election, you must establish material participation for each property separately, and must satisfy the more-than-50% test and the 750-hours test for each property separately in order to utilize the tax benefits of QREP status. Thus, if you don’t make the Grouping Election, obtaining QREP status for all your properties becomes more difficult (and may become impossible) as the number of properties increases. If you choose to make the Grouping Election, you only have to satisfy the above participation tests for the combined properties as a whole. If you make the Grouping Election, it applies both for QREP status, and for all other purposes of the PAL rules. The tax implications of the Grouping Election is discussed further on our website (found here).
Material participation in an activity means involvement in the operations on a regular, continuous, and substantial basis. If a taxpayer passes one of the following seven tests below that are enumerated in the Regulations, the IRS generally accepts that material participation has been established for an activity:
- Participating in the activity for more than 500 hours in the tax year (the most frequently utilized test);
- Participating in the activity if the taxpayer’s participation is substantially all of the participation in that activity by any individuals (including non-owners);
- Participating in the activity for more than 100 hours in the tax year, if nobody else (including non-owners) participated more;
- Participating significantly in the activity, if participation in all “significant participation” activities for the tax year exceeds 500 hours (but this test isn’t accepted for showing material participation in rental activities);
- Having materially participated in the activity during any five of the ten tax years before the year at issue;
- With respect to personal service activities, having materially participated in the activity for any three years (not necessarily consecutive) before the year at issue; or
- Showing regular, continuous and substantial participation on the basis of all the relevant facts and circumstances, but only if more than 100 hours of participation during the tax year can be shown (management services aren’t taken into account for purposes of this test unless certain stringent requirements are satisfied).
The extent of an individual’s material participation in an activity may be established by any reasonable means. But the most reliable means of showing material participation consists of contemporaneously kept appointment books, calendars, daily time reports, logs, or similar documents that provide a detailed account of what the taxpayer did with respect to an activity, when he or she did it, and how much time it took. Failure to substantiate material participation is one of the most common ways of losing the right to treat rental real estate activities as non-passive.
Due to the new 3.8% Medicare Surtax starting in 2013, real estate professionals are encouraged to plan for how this new tax will affect all their rental real estate activities. Real estate investment advisors at Convergence have the real estate industry expertise that is required to help you navigate through this complex area and formulate a plan to maximize the tax benefits available to you.
Should you have any questions about this article, or if we can improve your tax situation, please contact me, Darryl Dischler, at 303-951-2059 or firstname.lastname@example.org.
IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (1) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (2) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.