If the rental real estate property is used as your personal residence or even if it is used for only part of the year as your personal residence, then there are additional restrictions and limits on the deductibility of the rental costs. See Rental Property for some detail regarding this.
Advance rent and Prepaid rent and Deferred rent.
Otherwise, generally by default, rental real estate property results in passive income (loss) and net investment income (loss) for IRS purposes. Generally, the deductibility of such losses are limited, but can be deferred to be deducted in a future year.
There are three classifications for an individual to hold rental real estate:
- An investor who does not actively run the real estate rental property (such as a condo run by a management company, or a time-share property)
- A 10% or more owner of the real estate rental property, who actively makes independent judgments on what to do.
- A qualified materially participating real estate professional, making a living with development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or sales/brokerage. see Forbes and CRE Online and The Tax Advisor articles.
- The income of qualified real estate professional is non-passive. If it is earned in the ordinary course of a trade or business, then it is also exempt from the Net Investment Income Tax (NIIT or IRC §1411 Obamacare tax)
- To be earned in the ordinary course of a trade or business, then just like the rules for Trader Status, the real estate taxpayer’s involvement must be regular, continuous and substantial.
- If a real estate professional participates in a rental real estate activity for more than 500 hours per year – or for more than 500 hours in each of five of the last ten years – then the rental income associated with that activity will be presumed to be derived in the ordinary course of a trade or business.
Generally, a loss from a passive activity is not currently deductible unless one of the following applies:
- Passive income exists (losses are allowed to the extent of passive income);
- ○ But generally passive income from a publily traded partnership does not count, pursuant to IRC §469(k)
- The taxpayer actively participates in a rental real estate activity and qualifies for the $25,000 special allowance;
- There is a qualifying disposition (a sale of the property to an unrelated party) under IRC §469(g); or,
- The taxpayer meets the requirements of IRC §469(c)(7) for real estate professionals.
see IRS Audit Techniques Guide Chapter 2, Rental Losses
Actively Participates
As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager.
Several categories of taxpayers do not meet the standard of active participation and therefore do not qualify for the $25,000 special allowance:
- A limited partner in an activity (IRC §469(i)(6)(C)).
- A taxpayer who has less than 10 percent ownership (IRC §469(i)(6)(A)).
- A trust or corporation. The $25,000 is available only to natural persons.
The $25,000 rental real estate allowance under IRC §469(i) requires individuals to offset losses from rental real estate without necessarily having passive income.
A taxpayer must deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and MAGI is less than $100,000. If MAGI = $110,000, the $25,000 allowance is reduced by $5,000 to a $20,000 maximum allowance. Once MAGI exceeds $150,000, the special allowance is no longer available.
Modified Adjusted Gross Income (MAGI) is Adjusted Gross Income (AGI) computed without any passive losses and several other minor modifiers.
The activity must consist of rental real estate (not an equipment lease).
- The taxpayer must have “actively participated” in the rental.
- The MAGI must be less than $100,000 in order to obtain the full $25,000 benefit.
- Once MAGI exceeds $150,000, the special allowance is no longer available.
Real estate professionals
To qualify as a real estate professional, the taxpayer must spend:
-
- more than 50 percent of his/her time on his own real estate activities (a 5% owner /employee may count his hours on the job); AND,
- more than 750 hours in real estate activities in which you materially participate.
see Charles Gragg v. U.S.- When determining whether a person qualifies, each of their rental real estate interests are treated as a separate real estate activity unless a IRC §469(c)(7)(A) grouping election is made to treat all those interests as a single activity. Because of this rule, if someone has multiple rental properties and if they don’t make the election, they must establish material participation for each property separately including the 750-hours test for each property separately in order to qualify as a real estate professional with respect to that property.
- If someone has multiple rental properties and if they do make the election, they must dispose of all properties before deducting a loss. Hardy v. Commissioner, TC Memo 2017-16, 1/17/17
- Tax rules for real estate professionals
Materially participate
In order to materially participate in either a separate or aggregated rental activity, the taxpayer must pass one of the following seven tests found in Reg. §1.469-5T:
- The individual participates in the activity for more than 500 hours during such year;
- The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
- The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
- The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
- The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
- The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
- Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
A real estate professional must materially participate in each rental activity for the loss to be deductible. see Reg. §1.469-9(e)(1)
Exception: A real estate professional may file a written election to aggregate all rental real estate activities (including real estate held through passthrough entities) as one activity. As a practical matter, many elections were filed in 1995. However, the taxpayer may file the election in any year, and it will bind future years from that point. See Reg. §1.469-9(g) and IRC §469(c)(7)(A)
The due date for filing the election is the due date for filing the tax return (including extensions). An additional 6 months may be available by using Rev. Proc. 2011-34.
Real Estate Professionals: Avoiding the Passive Activity Loss Rules
Higher stakes for tax treatment of rental real estate
Electing to aggregate rental activities: Better late than never
Losses upon sale or disposition of a parcel cannot be recognized (deducted) until all rental activities in the aggregated group are sold or disposed of.
Chief Counsel Advice CCA 201428008