History of Passive Activity Loss Limitations & Real Estate Professionals
To understand the tax benefits of a Real Estate Professional, it’s helpful to start with the origin of Passive Activity Loss Limitations. Prior to the Tax Reform Act of 1986, an individual could write-off passive losses against their ordinary income. This allowed for rental losses (passive) to offset other income like wages (ordinary). Rental real estate can easily show tax losses due to non-cash depreciations deductions, along with mortgage interest and other expenses. Simultaneously, the property’s fair market value generally appreciates. As such, rental real estate created a double benefit for many individuals before the Tax Reform Act of 1986.
President Reagan put an end to this favorable tax treatment with the Tax Reform Act of 1986, which implemented Section 469 of the Internal Revenue Code – Passive Activity Loss Limitations. This code section limits what passive activity losses are allowed to be deducted. The result: individuals can no longer offset ordinary income with the losses from their rental property. Instead, the losses can only be used to offset other passive income. If there is not enough passive income to offset the entire passive loss in any given year, the losses are accumulated and carried forward indefinitely.
Here are examples before and after the Tax Reform Act of 1986:
- Pre-Tax Reform Act of 1986: Stuart, a physician, earns wages of $400,000. Stuart has significant disposable income and decides to purchase a rental property as an investment. The property is rented at fair market value but shows a $70,000 tax loss mainly due to depreciation. Stuart deducts this loss against his wages of $400,000, resulting in a net income of $330,000.
- Post-Tax Reform Act of 1986: John can no longer offset his ordinary income with the losses from his rental property. John’s $70,000 rental loss is therefore suspended until he has passive income in a future year. He will pay tax on his full wages of $400,000.
This tax treatment seems unfair to those individuals whose entire career is in real estate. In our example above, if Stuart owned a medical practice and it generated a loss, he would be able to deduct that loss against his other income – Real Estate Professionals should be able to do that same thing. Therefore, Section 469(c)(7) was added to the Internal Revenue Code, which defines who qualifies as a Real Estate Professional, and allows these individuals to offset ordinary income with their real estate losses.
Requirements & Qualifications
To be a Real Estate Professional in the eyes of the IRS, you must do a lot more than just own real estate. The IRS created a challenging list of qualifications to eliminate individuals trying to take advantage of the Real Estate Professional tax designation. Below outlines these qualifications and requirements:
- 50% of all personal services performed in a trade/business must be performed in real estate activities during the year. Therefore, if you spend 2,080 hours a year (40hrs/week) doing work for your W-2 employer, you must spend at least 2,081 hours actively participating in qualifying real estate activities AND
- You must spend more than 750 hours in the real estate trade/business during the year.
Even though you may qualify as a real estate professional, this does not necessarily mean you will be able to deduct 100% of your rental losses. The IRS has additional requirements to do so. To deduct 100% of all rental losses, one must also be materially participating in the rental activities. There is a list of 7 quantitative tests used to determine material participation and at least one of them must be met:
- The individual participates in the activity for more than 500 hours during the tax year.
- The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year.
- The individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year.
- The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
- The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year.
- The activity is a personal service activity (i.e., it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting or in any other trade or business in which capital is not a material income-producing factor), and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year (Temp. Regs. Sec. 1.469-5T(a)).
(Note, any work performed by the taxpayer’s spouse counts for the 7 tests listed above, but not for the two requirements to be a real estate professional.)
This material participation must be determined on a per property basis. Therefore, one property may qualify (taxpayer is able to deduct the loss) and a second property may not. Losses on the second property will be suspended and carried forward. However, one can make an election to aggregate the properties as one “activity” and the requirements above will be looked at in total – not on a per property basis. Any suspended losses at the time the election is made will most likely remain suspended until a “substantial portion” of the combined rental activities no longer exist. The election is only revokable if there are material changes to one’s tax situation.
The real estate professional designation is heavily scrutinized by the Internal Revenue Service (IRS); especially in circumstances when there are year-after-year losses offsetting other income. One must document and log, in detail, the qualifying aspects mentioned above. The IRS has been known to challenge this designation for lack of documentation, suspend the deductions, and impose penalty and interest on balance due.
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