Operation of Passive Real Estate Activity and Taxpayer Limitations

Managing Real Estate Broker with Keller Williams Northland

When you deal with clients/customers that are entrepreneurs and investors, you need to become somewhat more knowledgeable about tax implications than your competition. You know "if you can't razzle dazzle them with knowledge, hen baffle them with your bu.......". Then reccommed a good accountant.

The "Passive Loss Limitation Rules" inacted by Congress says that the Taxpayer must "materially participate" in a business to be elegible for tax preference benefits and incentives. The requirement is that the taxpayer must have a substantial and bona fide participation in the activities of the business.

-  Passive Loss Rules state that losses (credits) from a passive business or activity, to the extent they exceed income rom all passive acivity may not (generally) be applied against income from salaries, wages or interest and dividends. There are exceptions: 1. The real estate professional exemption (defined later), and 2. The $25,000 deduction of losses for middle income taxpayers (no corporations) from actively managed real estate.

-  Passive activity not currently deductible becomes suspended and is deductible in a subsequent year where there is passive income or the passive activity is terminated.

A taxpayer's activities must be divided into three types of acivities: Portfolio income - interest, dividends, royalties, annuities, investment income; Active Income - Salary/wages,Personal services, income froma business where there the taxpayer "materially participates;  and Passive Income.

To keep the taxpayers nose clean, its imprtant to define each activity in detail, because: 1. Is it a rental activity, 2. Has the activity been "completely" disposed of for tax loss calculations, 3. Application of rules from different passive loss regulations (Congress likes to keep you confused) and 4. Determining which activities where the taxpayer "materially participates."

  Material Participation means one of the following:  1. Working more tha 500 hours during the tax year (Jan 1 to Dec 31). The 500 hours does not have to be consecutive. If the taxpayer has multiple businesses or activities, the 500 hours test is applied to each one separately.  2. Do a majority of the work as measured of the total annual business hours (including the hours of employees and non-owners).  3 Worked a minimum of 100 hours and no else in the business worked more (ex. Partners have full time jobs and only work the business on weekends. the partner logging the majority of hours wins the loss deduction).  4. Working 500 hours total in a group of activities where the hours in each activity constitute a majority over the hours of others in that activity.

Taxpayers are required to separate income into acive, passive or portfolio, because (as explained to me) Congress wanted to insure that passive income generators -PIG, would not be used to offset nondeductible passive activity losses- PAL.

Should you have an involvement with individuals or partnerships, who appear to be active in several different enterprises, it is usually a good practice to layout their participation on a spreadsheet inorder to isolate any glitches before attempting to earn a commission which may not materialize. Not every accountant you meet will be knowledgeable in all aspects of real estate tax law; however, its a good idea to keep searching for one. As they say " a little knowledge can be dangerous."



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David Spencer

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