by David J. Hawks | David J. Hawks, CPA
Rental real estate is generally a passive investment in the eyes of the IRS. Under Internal Revenue Code Section 469, a taxpayer may only offset losses from a passive activity against income from a passive activity. This means that if you own a rental property that is incurring losses each year, you may not be able to deduct those losses unless you have other passive income. Some examples of passive income include self-charged interest and ownership interests in businesses in which you do not materially participate.
There is a $25,000 loss allowance for taxpayers who actively participate in the rental real estate activity and earn less than a specified amount of modified adjusted gross income (MAGI). Examples of actively participating include making management decisions or arranging for others to provide services. You do not have to do all the work yourself to claim the special allowance. The $25,000 loss allowance phases out between $100,000 and $150,000 MAGI, or $50,000 and $75,000 MAGI if you are married filing separately and you did not live with your spouse. If your income is below the threshold, you can take the loss against nonpassive income, such as wage income.
If your MAGI is too high to take advantage of the special allowance, another alternative is the real estate professional election. A rental activity of a taxpayer that qualifies as a real estate professional under Code Section 469(c)(7) is treated as nonpassive if the taxpayer materially participates in the activity. There are two specific guidelines to qualify as a real estate professional.
- More than one-half of the personal services the taxpayer performs in trades or businesses during the tax year is in real property trades or businesses in which the taxpayer materially participates. In other words, if you have a W-2 job that is not related to real estate, you must spend at least as much time in real estate activities as your regular job.
- The hours spent providing personal services in real property trades or businesses in which the taxpayer materially participates total more than 750 during the tax year.
In addition, the real estate professional must establish material participation in each rental activity separately. The good news is that the taxpayer can elect to aggregate all his or her interests in rental real estate for purposes of determining material participation. For married couples, the taxpayer may include the hours of his or her spouse in determining whether material participation has been achieved. However, the taxpayer must pass the two tests above using his or her own hours.
Another benefit of the real estate professional status is the ability to avoid the net investment income tax (NIIT). Passive income from rental activities is generally subject to the NIIT. This additional tax does not apply to qualifying real estate professionals whose income is derived in the ordinary course of a trade or business.
Ultimately, if you own rental real estate, it is important to take advantage of the losses available to you. If you earn too much income to be eligible for the $25,000 allowance, you may still qualify as a real estate professional. The election can reduce your taxable income and help you avoid the pesky NIIT.
If you need the help of a CPA who understands real estate taxation, you can call me David J. Hawks, CPA, EA at (480) 626-5557 or email at email@example.com.