Real estate pros can deduct rental losses

Real Estate Tax Talk

A recent court decision will make it easier for many individuals to qualify as real estate professionals for purposes of the IRS passive loss rules. This will enable more landlords to fully deduct their losses from real estate rentals.

The passive loss rules ("PAL rules") are one of the most confusing areas of taxation. Under these rules, losses from real property rentals are classified as "passive activity losses." These rules permit a rental property to deduct from his other non-passive income, such as salary or other business income, a maximum of $25,000 each year; and even this is phased out if the owner’s adjust gross income exceeds $100,000. Unused losses must be saved for future years.

Luckily for real estate professionals, they can qualify for a special exemption from the passive loss rules — an exemption nobody else can get. If you qualify, you may deduct any amount of rental activity losses you have for the year from your other income — such as real estate commission income — regardless of how high your income for the year may be.

To qualify as a real estate professional, you (or your spouse, if you file a joint return) must:

  • spend more than half of your working hours during the year working in one or more real property businesses, and
  • you (or your spouse, if you file a joint return) must spend more than 751 hours a year in one or more real property businesses in which you materially participate.

A real property business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage business.

Coming up with all these hours working in real estate can be very difficult for people who have other jobs. Indeed, it’s virtually impossible for a person with a full-time jot to qualify as a real estate professional under the PAL rules.

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However, a Sept. 12 decision by the United States Tax Court makes it easier for some real estate pros to accumulate enough hours.

Fred Chambers, a civilian Navy employee, individually owned a rental property that produced losses. He also was a member and manager of a Tennessee LLC that owned several rental properties. The LLC also produced losses, 33 percent of which were allocated to Chambers. The only way Chambers could deduct all these losses from his active employee income was to qualify as a real estate professional.

To establish sufficient hours to qualify as a real estate professional, Chambers counted the time he spent managing his individually owned property and the time he spend managing the LLC.

The IRS argued that he shouldn’t have counted the LLC time because the LLC was a limited partnership for tax purposes and Chambers functioned as a limited partner. The PAL rules provide that all limited partnership interests are passive and thus time managing them can’t be used for purposes of the real estate professional exemption.

However, the Tax Court held that Chambers could count the hours he spent on the LLC in his total real estate professional hours.

The court held that Chambers should be viewed as a general partner because (1) under Tennessee laws LLC members may participate in management of the LLC, and (2) Chambers was required to participate in its management under the articles of organization and in fact did so.

Because Chambers established that he materially participated in the LLC, he could count the hours spent working on it for purposes of the real estate professional test (Chambers v. Commissioner of Internal Revenue, T.C. Summ. Op. 2012-91)

Unfortunately, even counting his LLC hours, Chambers was unable to qualify as a real estate professional. However, under this case, others who actively manage one or more LLCs that own real estate can count the hours they spend to help them qualify as real estate professionals.

Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.

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