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What Qualifies You as a Real Estate Professional?
Imagine working for yourself in a flexible career, where you can set your own schedule and be your own boss. There are plenty of reasons to choose real estate as a career, but there are always two sides to every story. Becoming a real estate professional is no different.
Rental real estate commonly generates losses in the early years, when the property is placed in service, while depreciation and mortgage payments are still being made. Rental real estate losses are typically considered passive, meaning that in order to utilize rental losses, you must overcome passive loss limitation rules and other hurdles. When all is said and done, this means you can only use passive losses to offset passive income.
There is an opportunity to utilize $25,000 of rental real estate losses each year, regardless if passive income is present. Not surprisingly, there are limitations associated with this deduction. For individuals with a modified adjusted gross income of $100,000 or less, you can deduct up to $25,000 in real estate losses. On the other hand, if you generate rental income it may be subject to an additional 3.8% tax, because passive rental income is considered investment income. Definitely not the outcome you were seeking.
So, how does being a real estate professional change these problems?
- As a real estate professional, you will be able to treat all your real estate activities in which you materially participate as non-passive.
- The $25,000 rental loss limitations no longer apply to you.
- Your real estate-related activities are now considered as trade or business income, and no longer subject to the additional 3.8% net investment income tax.
A taxpayer qualifies as a real estate professional if:
- More than one-half of the personal services performed by the taxpayer in the trades or businesses during the tax year are in the real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
As you can see, becoming a real estate professional is difficult if you have a full time job in another industry.
Let's take a look at what constitutes a real property trade or business. A real property trade or business is broadly defined to include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and brokerage.
Relative to material participation, in order to materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis. The seven tests that measure this are:
- 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 the 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 the 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, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
The taxpayer must materially participate in each passive activity separately. This means if you own 5 rentals, you must show you materially participated in each individual rental activity, which can be extremely difficult to do. To get around this, you can make a grouping election. It is strongly recommended you speak to a CPA prior to this, as the election can have negative long-term consequences.
It is important to note that any grouping election made is effective beginning in the year made and all future years, even if your status as a real estate professional changes. The only time you may change the grouping is in a year in which there is a material change in circumstances. You should be cognizant of any prior suspended passive losses (when activities which were previously considered passive had losses which you were unable to use). Generally, when you dispose of that activity, all previously suspended passive losses would be released and offset any income generated in the year of disposition. However, if you were to group this activity with other activities, any suspended passive losses would remain suspended until all or substantially all activities in the group are sold.
Finally, it is imperative to note that you must keep contemporaneous records. Those records need to be absolutely bulletproof to substantiate your real estate professional status claim with the IRS. If you are considering becoming a real estate professional, please do not hesitate to contact your tax advisor at Dermody, Burke & Brown.
The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.