The rules that define real estate activities for tax purposes can be confusing. Is the real estate business you conduct considered passive activity or could you be defined as a real estate professional?
Generally, your deductions for investments in passive activities — business activities in which the taxpayer does not materially participate, such as rental real estate and other classic “tax shelters” — are limited to the annual income from those activities. Thus, you can’t deduct a loss. Any excess losses are suspended and may be carried over to the next year.
However, you may be able to salvage a partial loss tax deduction if you actively participate in a real estate activity. Furthermore, if you prove you’re a real estate professional, you can deduct your losses in full.
Although rental real estate activity is automatically treated as a passive activity, there’s a limited exception for active participants who interview tenants, arrange repairs, etc. In such cases, you may use a loss of up to $25,000 to offset non-passive income. This $25,000 offset is phased out if your modified adjusted gross income (MAGI) is between $100,000 and $150,000.
But real estate professionals don’t face these restraints. If you meet the following two key requirements, you can fully deduct your loss against other highly taxed income without regard to your MAGI.
- More than half of the personal services you perform in all trades or businesses during the tax year are performed in real estate trades or businesses in which you materially participate.
- You perform more than 750 hours of services during the tax year in real estate trades or businesses in which you materially participate.
Interestingly, the IRS has contested this classification in court. In one new case, the owner of an insurance company who also owned ten rental properties couldn’t convince the Tax Court that he spent more than half of his time on real estate services (Jones, TC Summary Opinion 2017-6). But a dentist who saw patients only four afternoons a week was able to prove that he spent more time on his four rental units (Zarrinnegar, TC Memo 2017-34).
If you claim to be a real estate professional, recordkeeping is essential. Keep in mind that you do not have to navigate these complex rules alone. Give us a call. We’re here to help.