Do you have a number of real estate properties that are creating losses that you would like to deduct against your other income for tax purposes? Under the passive activity loss (PAL) rules, this would normally be impossible. In general, passive losses cannot be deducted against nonpassive income (such as salary, interest, dividends, or income from a business you materially participate in).
There is an exception where a taxpayer can deduct up to $25,000 of losses from real estate activities against nonpassive income from an activity that the taxpayer actively participates in. This exception begins to phase out if the taxpayer’s adjusted gross income exceeds $100,000. However, if you materially participate in rental real estate activities, you may qualify to be classified as a “real estate professional”. One of the advantages of being classified as a real estate professional is that losses from real estate activities can be used to offset other ordinary income such as wages, interest, or other nonpassive income.
Under IRC Sec. 469(c)(7)(B), an individual is eligible to be classified as a real estate professional if:
- The taxpayer materially participates, and more than half of their personal service time performed is attributable to real property trades or business, and
- The taxpayer spends greater than 750 service hours during the tax year materially participating in real property trades or business. Only time actually spent on performance or services qualifies towards the 750 hours. Being on-call or willing to work will not count towards the 750 hours, but travel time between rentals properties will.
IRC Sec 469(c)(7)(C) broadly defines real property trades or businesses as real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
In order to be eligible for this classification, an individual or closely held C Corporation must materially participate in the rental real estate activity. The taxpayer would need to meet one of seven tests in order to be considered materially participating in an activity. If the taxpayer is a limited partner in a Limited Partnership, they only need to meet one of three tests in order to qualify. There is also an election the taxpayer can make to aggregate their rental activities when determining material participation.
The tests for determining whether you qualify as a real estate professional are applied annually. That means some years you may qualify as a real estate professional, but not in other years. The losses from your rental real estate activity are not automatically treated as passive if you qualify as a real estate professional. If you materially participate in the rental real estate activity, any losses would be treated as nonpassive and, as a result, be able to offset other nonpassive income.
For additional information on qualifying as a real estate professional, click here.
If you want to know whether or not you qualify, or would like more information, please reach out via email, give us a call at (401) 921-2000, or fill out our online contact us form.