In my former life as a full-time tax advisor, I used to say that my primary job between March 15 and April 15 was grief counseling. People who owed money or had sticky tax problems would usually wait to see me as late as possible during the filing season. Some of the worst news I had to deliver was telling someone with a loss that it could not be deducted. This was particularly true of real estate investors who may have been counting on a paper loss from depreciation write-offs to offset income from their day job. If your income is at or above $100,000 or you are not a real estate professional, your real estate losses might not be tax deductible. Let me explain why.
Types of Passive Activities
There are two types of passive activities:
1. Limited Partnerships where the taxpayer did not materially participate.
2. ALL rental real estate (unless you are a professional).
The IRS makes a distinction between the treatment of ordinary income and passive income. Even more importantly, losses from passive activities are limited.
Types of Participation in Real Estate (From Publication 925)
Active and material participation are not the same.
Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions. So, a real estate investor who hires a property manager, would be managing the manager and this would qualify as active participation under this standard.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:
1. You participated in the activity for more than 500 hours.
2. Your participation was substantially all the work in the activity, of all individuals for the tax year.
3. 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 did not own any interest in the activity) for the year.
4. 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 did not materially participate under any of the material participation tests, other than this test.
5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. 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 is not a material income-producing factor.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
You did not 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 does not count in determining whether you materially participated under this test if:
· Any person other than you received compensation for managing the activity, so managing the manager, 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
Taxation of Real Estate Income
Here is a brief summary of the taxation of passive activities and specifically rental real estate:
1. Passive income is taxed at ordinary rates the same as wages, dividends or interest. So, rental income net of expenses is taxed at ordinary rates.
2. Passive losses can offset passive income dollar for dollar. A loss from one passive activity can offset income from another passive activity. For example, a loss from a limited partnership interest in your brother-in-law’s llama breeding operation can offset income from the duplex you own.
3. If there is active participation (defined above) and at least 10% ownership, passive losses in excess of passive income can offset ordinary income (wages, dividends, interest) up to $25,000. However, this is only allowed if adjusted gross income (AGI) is less than $100,000. This benefit is phased out at AGI between $100,000 and $150,000. Also, NNN leased properties and vacation homes do not qualify.
4. Unallowed passive losses, called “suspended” in the tax code, can be carried forward indefinitely until there is passive income to offset, AGI drops below the limitation threshold or the property is sold. In the year of sale, any suspended losses can be deducted (no $25,000 limitation).
5. Depreciation – the “benefits” of depreciation are that you can claim as a deduction a certain portion of the acquisition value of a rental property. For residential property the recovery period is 27.5 years; For commercial property, it’s 39 years. Depreciation lowers your income taxes in the current year. In the year of sale, the cumulative depreciation deductions are recaptured and taxed at a maximum rate of 25%. Depreciation is a deferral of tax.
6. 20% Qualified Business Income Deduction or Section 199a Deduction- to qualify for the Section 199a deduction the real estate activity must qualify as a trade or business. These rules seem confusing given the material participation rules, but the Section 199a safe harbor for participation in your rental activity is 250 hours of direct participation. And remember what we are measuring: material participation to deduct losses, a safe harbor of 250 hours to take the 20% deduction. You’ll never have the 199a deduction if you have a net loss.
There are tax advantages to owning real estate, but don’t let the tax considerations drive your decisions. Purchasing real estate directly or participating in a syndication or fund should always be an economic decision.
The rules discussed today are complex. Please consult with your tax advisor before concluding on the correct approach for your own facts and circumstances. If you own or invest in rental real estate, I recommend using a professional tax preparer. If you need a referral, please contact me.
Kelley Treon, CPA, Principal email@example.com Lonicera Investments