The vast majority of the time, it’s best for married people to file a joint return. However, there are situations where they can save on taxes by filing separately.
For example, a married couple may save tax by filing separately if one spouse has substantial medical expenses, miscellaneous expenses or casualty losses, due to floors that limit these deductions. A spouse may also wish to file separately to avoid being jointly liable for the other spouse’s taxes.
However, filing separately has many tax ramifications, most of them bad. One of the less well-known is the impact married filing separately status has on the ability to deduct rental losses, whether by qualifying as a real estate professional or by utilizing the $25,000 rental loss offset available to all landlords with incomes below certain levels. If you need such to deduct rental losses, think twice about filing separately.
This is what Julie A. Oderio found out. She owned a rental property that incurred a $29,583 loss in 2008. For reasons that are unclear, she and her husband Jason filed separate tax returns for that year. The IRS later audited Julie and denied her 2008 rental loss.
Real estate professional status
Julie claimed that she was entitled to deduct the loss because she qualified as a real estate professional. Unlike everybody else, real estate professionals are allowed an unlimited annual deduction for rental losses. However, to qualify as a real estate pro a landlord must:
- spend more than half (at least 51 percent) of his or her total working hours during the year working in one or more real property businesses;
- spend more than 751 hours a year in one or more real property businesses; and
- materially participate in the rental activity and any other real property businesses used to pass the 51 percent and 751-hour tests.
Julie admitted that she did not meet the 51 percent or 751-hour tests to qualify as a real estate pro. Although she worked full time for a real estate investment company, she was an employee who failed the ownership test, so this time did not count. If you are an employee in someone else’s real property business, your time counts toward real estate professional status only if you own more than 5 percent of the business. If you work as an employee for a corporation, you must own more than 5 percent of your employer’s outstanding stock.
However, Julie argued that her spouse Jason did meet the 51 percent and 751-hour tests and therefore she satisfied them too because his efforts were attributable to her. This can be true, but only if spouses file a joint return. In this event, the 51 percent and 751-hour tests are satisfied if either spouse meets them — but one spouse must satisfy both. For the third material participation test, both spouses’ time together is counted regardless of whether they file a joint return.
But there is no attribution of one spouse’s time working in real estate to the other if they each file separate tax returns. This means that a married taxpayer who files a separate return must separately satisfy the 51 percent and 751-hour tests. As a result, Julie could not deduct her $29,583 rental loss on the grounds that she was a real estate professional. Had she filed jointly, she could have so qualified and taken this deduction.
$25,000 rental loss offset
What about the $25,000 offset? Landlords who don’t qualify as real estate professionals may deduct up to $25,000 in rental losses each year if their modified adjusted gross income is below $100,000. The offset is phased out at income levels of $100,000-$150,000. The offset amount is $25,000 for both single and married taxpayers filing joint returns.
Married people who file separate tax returns and live separately for the entire year are each entitled to a $12,500 offset. However, married people who file separate returns and live together any time during the year get no offset at all. (I.R.C. § 469(i)(5)(B).) The tax court held that Julie Oderio did not qualify for the offset because she didn’t live apart from her husband Jason for the entire year. So filing separately cost her a $25,000 deduction. (Oderio v. Comm’r, TC Memo. 2014-39.)
Stephen Fishman is a tax expert, attorney and author who has published 20 books, including “The Real Estate Agent’s Tax Deduction Guide,” “Working for Yourself,” “Deduct It!” and “Working with Independent Contractors.” His website can be found at fishmanlawandtaxfiles.com.