As the 2024 tax season begins to wind down, we all will be looking for ways to reduce our tax liability. If you’re a taxpayer with income from rental activities or other real estate investments, one unique way to do this is to explore whether the IRS may also consider you to be a real estate professional. If so, losses and credits from your rental properties may result in significant tax savings. This month, we welcome guest author Darren Thomas, tax director at Traphagen CPAs and Wealth Advisors, to explain the requirements needed to take advantage of this beneficial tax designation.
Qualifying as a real estate professional
Many taxpayers may be in a situation where, in addition to a regular business (which has nothing to do with real estate), they have several rental real estate properties that are generating losses that they would like to deduct against other income for tax purposes.
Those grand plans are normally prevented by the so-called “passive activity loss (PAL) rules.” Per those rules, losses from passive activities, that is activities in which you do not “materially participate” cannot be deducted against nonpassive activity income (such as salary, professional fees, income from a business in which you do materially participate, interest, or dividends). Also, credits from passive activities cannot be used to reduce taxes on nonpassive activity income.
Pursuant to the PAL rules, rental real estate activities are automatically treated as passive activities, even if the owner “materially participates” in their management, operations, etc. As a result, tax losses from rental realty cannot be deducted against nonpassive income.
A key exception to the PAL rules, and the subject of this tax alert, is the “real estate professional” exception. If you qualify as a real estate professional, your rental real estate interests are not automatically treated as passive activities. As such, if you materially participate in the rental real estate activity, the activity will not be treated as passive, and you will be entitled to deduct losses from that activity against nonpassive income.
What does it take to qualify as a real estate professional?
There are three requirements.
- You must materially participate (covered below) in a real estate business. The business of renting and leasing realty is a real estate business.
- More than 50% of the personal services you perform in all businesses during the year must be performed in real estate businesses in which you materially participate.
- Your personal services in material participation real property businesses during the year must amount to more than 750 hours. You cannot count any work you perform in your capacity as an investor.
In determining whether you qualify as a real estate professional, each of your rental real estate interests is treated as a separate activity, that is, as a separate business unless you make an election to treat all those interests as a single activity. Because of this rule, if you have multiple rental properties and you do not make the election, you must establish material participation for each property separately, and must satisfy the more-than-50% test and the 750-hours test for each property separately to qualify as a real estate professional with respect to that property. And qualifying for one property does not mean you qualify for any other property. As such, if you do not make the election, qualifying as a real estate professional for all your properties becomes more difficult (and may become impossible) as the number of properties increases. However, if you do make the election, you only must establish material participation, and satisfy the more-than-50% test and the 750-hours test, for the combined properties.
You do not have to work full-time in real estate to qualify as a real estate professional. Even if you have another occupation, you can qualify if you materially participate in a real estate business, and spend more time, and more than 750 hours, on that business.
The tests are applied annually. As such, you may qualify as a real estate professional in some years but not in other years. As a result, the same real estate activity may generate passive losses in some years and nonpassive losses in other years.
If you qualify as a real estate professional, your rental real estate properties are not automatically treated as passive. However, this does not mean that they are automatically treated as nonpassive. It just means that, if you materially participate (as explained below) in the operation of a rental real estate property, then it will be treated as nonpassive, and you may deduct losses from that property against other nonpassive income.
What is material participation in an activity?
Material participation in an activity means involvement in the operations of the activity on a regular, continuous, and substantial basis. The IRS has established a list of seven tests. If a taxpayer passes one of the seven tests, the IRS accepts that as establishing material participation in an activity. We won’t discuss all seven tests here, but the most frequently utilized test is “participating in the activity for more than 500 hours in the tax year.” If you don’t meet this test, we can analyze your situation to determine if it meets any of the six other tests. You can read more details on all seven tests here, or see a flowchart to help determine whether you materially participate in an activity here.
The extent of an individual’s material participation in an activity may be established by any reasonable means. But the most reliable means of showing material participation consists of contemporaneously kept appointment books, calendars, daily time reports, logs, or similar documents that provide a detailed account of what the taxpayer did with respect to an activity, when he or she did it, and how much time it took. Failure to substantiate material participation is one of the most common ways of losing the right to treat rental real estate activities as nonpassive.
This article covers only some of the tax rules related to qualifying as a real estate professional that could potentially impact you or your family. The tax rules in this area are complex and there are many issues to consider in qualifying as a real estate professional. Please contact Darren Thomas at 201.262.1040 ext. 403 or [email protected] if you have questions, want more information, or would like him to help you with qualifying as a real estate professional. To learn more about other services offered by Traphagen CPAs & Wealth Advisors, go to: https://tfgllc.com.
