IMPORTANT TAX TERMS TO KNOW FOR THE REAL ESTATE BUSINESS
By IRS definition, rental real estate is a passive activity.
Rental real estate may have limited losses unless one of the exceptions applies.
In addition, you do not need to be a licensed real estate agent or broker to qualify as a Real Estate Professional, many real estate investors will also qualify as a real estate professional in the eyes of the IRS.
It's important to consult with a tax professional or accountant for specific guidance on how these terms and rules apply to your tax situation. Almost all tax laws have limitations, exclusions or exceptions. Also, many tax situations are based on facts and circumstances of the situation and the taxpayer’s intent, finally tax laws and regulations can and do change, sometimes yearly.
The IRS has established specific criteria to define a real estate professional for tax purposes. This designation offers certain advantages that can significantly impact the tax treatment of real estate investments.
In this posting, we will explore the IRS definition of a real estate professional and discuss the benefits associated with this status.
For those that are not real estate professionals, rental real estate losses may be limited.
Limits on Rental Real Estate Losses
If you have a loss from your rental real estate activity, two sets of rules may limit the amount of loss you can deduct. You must consider these rules in the order shown below.
- At-risk rules. These rules are applied first if there is investment in your rental real estate activity for which you aren’t at risk.
- Passive activity limits. Generally, rental real estate activities are considered passive activities and losses aren’t deductible unless you have income from other passive activities to offset them. However, there are exceptions.
Excess business loss limitation.
In addition to at-risk rules and passive activity limits, excess business loss rules apply to losses from all noncorporate trades or businesses. Any limitation to your loss resulting from these rules will be treated as a net operating loss that must be carried forward and deducted in a subsequent year.
At-Risk Rules
You may be subject to the at-risk rules if you have:
- A loss from an activity carried on as a trade or business or for the production of income, and
- Amounts invested in the activity for which you are not fully at risk.
In most cases, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. Any loss that is disallowed
Passive Activity Limits
In most cases, all rental real estate activities (except those of certain Real Estate Professional) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services.
Deductions or losses from passive activities are limited. You generally can’t offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year.
Special Allowance for Rental Real Estate Activities with Active Participation.
If you actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.
Exception for Rental Real Estate with Active Participation
If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you may be able to offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.
Note: The special allowance isn’t available if you were married, lived with your spouse at any time during the year, and are filing a separate return.
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Active participation.
You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.
Maximum special allowance.
The maximum special allowance is:
- $25,000 for single individuals and married individuals filing a joint return for the tax year,
- $12,500 for married individuals who file separate returns for the tax year and lived apart from their spouses at all times during the tax year, and
- $25,000 for a qualifying estate reduced by the special allowance for which the surviving spouse qualified.
If your MAGI is $100,000 or less ($50,000 or less if married filing separately), you can deduct your loss up to the amount specified above. If your MAGI is more than $100,000 (more than $50,000 if married filing separately), your special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your MAGI.
Generally, if your MAGI is $150,000 or more ($75,000 or more if you are married filing separately), there is no special allowance.
The Real estate professionals.
If you qualify as a real estate professional as defined by the IRS for the tax year, you need to meet both of the following requirements.
- More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
- You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.
If you qualify as a real estate professional, rental real estate activities in which you materially participated will not be treated as passive activities.
To determine whether you materially participated in your rental real estate activities, each interest in rental real estate is a separate activity unless you elect to treat all your interests in rental real estate as one activity.
Don’t count personal services you perform as an employee in real property trades or businesses unless you are a 5% owner of your employer. You are a 5% owner if you own (or are considered to own) more than 5% of your employer's outstanding stock, or capital or profits interest.
Don’t count your spouse's personal services to determine whether you met the requirements listed earlier to qualify as a real estate professional. However, you can count your spouse's participation in an activity in determining if you materially participated.
Real property trades or businesses.
A real property trade or business is a trade or business that does any of the following with real property.
- Develops or redevelops it.
- Constructs or reconstructs it.
- Acquires it.
- Converts it.
- Rents or leases it.
- Operates or manages it.
- Brokers it.
Choice to treat all interests as one activity.
If you were a real estate professional and had more than one rental real estate interest during the year, you can choose to treat all the interests as one activity. You can make this choice for any year that you qualify as a real estate professional. If you forgo making the choice for one year, you can still make it for a later year.
If you make the choice, it is binding for the tax year you make it and for any later year that you are a real estate professional. This is true even if you aren’t a real estate professional in any intervening year. (For that year, the exception for real estate professionals won’t apply in determining whether your activity is subject to the passive activity rules.)
Material participation.
Generally, you materially participated in an activity for the tax year if you were involved in its operations on a regular, continuous, and substantial basis during the year.
Material Participation in a trade or business activity isn’t a passive activity if you materially participated in the activity.
Material participation tests.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. You didn’t materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if:
- Any person other than you received compensation for managing the activity, or
- Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).
Participating spouse.
If you are married, determine whether you materially participated in an activity by also counting any participation in the activity by your spouse during the year. Do this even if your spouse has no interest in the activity or files a separate return for the year.
I wish I could say trying to correctly determine how to qualify and apply the numerous and many times overlapping criteria is easy and straightforward.
As you can see, the actual determination may be very difficult to determine.
But if you qualify as a real estate professional under the IRS definition can offer significant tax advantages for individuals involved in real estate trades or businesses. By meeting the criteria of spending more than 50% of personal services time and substantial participation, investors can benefit from relief in passive activity loss limitations, exemption from the Net Investment Income Tax, increased deductibility of rental property expenses, and more.
I wish I could tell you that rental real estate losses and the potential passive activity limits was a simple determination.
I also wish I could tell you how simple it is to make a determination if you qualify for an exception of if you will meet the definition of a Real Estate Professional for Tax Purposes.
You can see firsthand that is not a simple process.
But if you meet the definition for a real estate professional or the exception for passive activity losses, you and your clients may open the door to significant tax savings.
At www.TaxReliefServices.com we have Tax Relief in Our DNA!
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