Small Business Taxes & ManagementTM--Copyright 2011, A/N Group, Inc.
If you have a rental property, whether it's a small strip center, a home you inherited from your parents, or just a vacation home that you rent during the off season, your rental losses are generally limited through the passive activity rules. The passive activity rules only allow losses from passive activities to offset income from passive activities. Some activities, like real estate rentals, are inherently passive. Other activities, such as a LLC or S corporation that operates a retail business isn't passive per se, but to the member or shareholder it's passive unless that individual materially participates in the activity. (For a definition of material participation, go to our article Material Participation.)
There's a special exception for rental real estate. If you can show you actively participate in the activity, losses of up to $25,000 a year can be used to offset ordinary income as long as your adjusted gross income (AGI) is $100,000 or less. For every $1 of AGI over $100,000, the $25,000 exemption is reduced by $0.50. Thus, if your AGI exceeds $150,000, none of the losses come under the exemption. Instead, the losses can only be used to offset passive income from rental real estate or carried forward to be used under the same rules in subsequent years. Any accumulated losses can also be deducted on the disposition of the property.
The $25,000 exemption may be cold comfort for many taxpayers. It's pretty easy to broach the $100,000 AGI threshold (which hasn't changed since it was put in the law in 1986). And, as a result, the limitation allows the losses to be used only when you're in a lower bracket.
Real Estate Professionals
Some investors have another option. "Qualifying taxpayers" also known as "real estate professionals" can deduct rental property losses without the limitations discussed above. For example, you've got three rental properties where the net losses from the properties total $75,000. If you qualify, the entire $75,000 can be deducted. A taxpayer is a real estate professional if:
Real property trade or business, as defined here, means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. If you are an employee of the business, the work only counts if you are at least a 5-percent owner at all times during the year. For example, you have a 50%-interest in an LLC in the construction business.
Taxpayers who have a number of properties may meet the 750-hour threshold by simply working on the properties. For example, Sue owns five single-family properties and a seven-unit strip mall. She also has at least one property she's rehabbing at all times. She not only does recordkeeping, banking, and administrative functions for the properties, she oversees maintenance, renovations, gets building permits, etc. Her time spent at these activities during the year exceeds 750 hours and, aside from a couple of hours a week working for her husband's business, that's her only trade or business. Sue qualifies as a real estate professional.
Fred is in much the same situation as Sue. He has a number of rental properties and materially participates in the management for 800 hours during the year. However, Fred is a attorney who spends 1,200 hours a year in his legal practice, almost all drafting leases and purchase and sale agreements for real estate. Since he doesn't spend more than one-half of his time performing personal services in the real property trade or businesses (he's in the legal profession), he doesn't meet the second part of the test above.
Some other points:
Generally, you have to meet the 750-hour and more than half of your personal services in the real estate activity for each property. However, you can make an election to group all your properties for purposes of meeting the requirement and deducting the losses. You can do this by filing a statement with your original return for the tax year for which the election is to first apply. Simply grouping the properties, deducting the net losses and checking the box on the second page of Schedule E won't meet the requirement. While there is no set wording, you must state the election is made under IRC Sec. 469(c)(7)(A) and that you want to group all your interests in rental real estate as a single rental real estate activity. The election, once made is irrevocable unless there's a material change in the your circumstances. Talk to your tax advisor.
In a recent revenue procedure (Rev. Proc. 2011-34, IRB 2011-24) the IRS recognized that many taxpayers were not aware of the requirement to file a statement to group the properties. The revenue procedure provides a means for taxpayers to make a late election that will be considered as timely filed. In order to meet the requirements of the procedure, you must have filed consistently with having made an election on any return that would have been affected if you had timely made the election. You must have filed all required federal income tax returns consistent with the requested aggregation to be effective. You must also have timely filed the returns. A return will be treated as timely filed if the return is filed within 6 months after its due date, including extensions. You must also have a reasonable cause for failure to file the statement.
If you can't comply with the requirements of Rev. Proc. 2011-34, you may still be able to correct a late filed election, but you'll have to apply for a letter ruling.
If you're audited you can expect the agent to scrutinize the facts to make sure you qualify as a real estate professional. If you have a regular job, meeting the more than one-half requirement will be difficult, and the IRS knows it. Meeting the 750-hour requirement is not easy, nor is the material participation requirement. The best approach is to keep a log or diary of your activities, detailing work performed, hours, etc. It'll help if you can substantiate your entry with receipts, invoices, etc. For example, a trip to the hardware store on 6/11 can be substantiated with a receipt for plumbing supplies. While there are other ways to substantiate your time, a well-kept, contemporaneous log or diary should forestall any questions by the agent.
Copyright 2011 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 06/09/11