Life isn’t exactly easy for most real estate professionals these days. But real estate pros who own rental property have one thing going for them that others don’t: special tax advantages.
Let’s say that you are a rental property owner and you spend more on the property than you earn during the year — a depressingly common occurrence these days. Naturally, you’d like to be able to deduct your loss from any nonrental income you have, thereby reducing your taxable income and lowering your taxes for the year.
Unfortunately, losses from real property rentals are classified as "passive activity losses." Special passive activity loss rules greatly limit the amount of losses that a rental property owner can deduct from other nonpassive income, such as salary or other business income.
A maximum of $25,000 can be deducted from nonpassive income each year, and even this is phased out if the owner’s adjusted gross income exceeds $100,000. Unused losses must be saved for future years.
But real estate professionals 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 (see Internal Revenue Code Section 469(7)).
For example, a real estate broker who loses $100,000 from his rentals could deduct the entire amount from his commission income.
Unfortunately, the rules for determining who qualifies for the real estate professional exemption from the passive loss rules are complex. Basically, 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.
In addition, 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. A real property business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage business (per the code section cited above). It includes working as a real estate broker or self-employed salesperson.
In addition, you must "materially participate" in your rental activity to qualify for the exemption. This requires that you work a certain number of hours at your rental activity during the year. For example, you would materially participate if you work at least 500 hours during the year at the activity. You can qualify in other ways as well.
If you own more than one rental property, here’s a key point to understand: You are required to materially participate for each rental property you own unless you file an election with the Internal Revenue Service to treat all of your properties as one, single activity.
In this way, you can combine the time you spend working on each rental property to satisfy the material participation test. If you fail to file the election, you’ll have to materially participate for each rental property you own.
For most landlords, this is impossible to do, which makes filing a timely election very important.
Example: Dennis owns five rental homes. He works 500 hours a year managing all five, and no one else does any work on the properties. If he files an election with his tax return to treat all his properties as one rental activity, he’ll pass the 500-hour material participation test.
However, if he fails to file the election, he’ll have to materially participate for each house he owns — that is, he’d have to work 500 hours on each house, instead of all five together.
To make an election to treat all your rental activities as one activity, you’ll need to draft a statement like the following and attach it to your tax return:
"Tax Year:__________ Taxpayer Name:___________
"Taxpayer Identification Number: _______________
"In accordance with Regulation 1.469-9(g)(3), taxpayer states that he/she is a qualifying real estate professional, and elects under IRC Section 469(7)(A) to treat all interests in real estate as a single rental real estate activity.
The election can be filed any year you qualify for the real estate professional exemption, and needs to be filed only once. It applies to all future years that you qualify for the exemption. It may only be revoked if you have a "material change" in circumstances.
The fact that the election is less advantageous to you in a particular year is not a material change in circumstances (see: IRS Reg. 1.469-9(g)).
If you are audited by the IRS, the key to preserving your real estate professional exemption is good records of your annual work hours. IRS regulations provide that you may use any "reasonable means" to keep track of your work time, including daily time reports, logs, appointment books, calendars, or narrative summaries (see: IRS Reg. 1.469-5T(f)(4).)
You are not absolutely required to keep contemporaneous records — that is, records made at or near the time you did the work involved — but it is a good practice to do so.
Got a real estate tax question? Ask below …
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.