If you own rental property, the rental activity is generally treated by the IRS as a “passive activity.” This is important to understand because if you operated rental property and sustained a loss, the loss can be claimed against active income, such as wages. This loss deduction is limited to $25,000 for the claimed tax year. The $25,000 loss deduction may be further limited by Adjusted Gross Income (AGI). However, if you are a bona fide real estate professional, the rental activity is treated as an “active activity.” Therefore, there is no limit on the amount of losses that can be deducted.
Before you consider identifying yourself as a real estate professional for tax purposes, you must understand the tax rules for making this determination. I strongly recommend that you review these rules with a C.P.A. for additional help.
- Under IRC § 469(c)(7), the rental activity of a taxpayer in the real property business (real estate professional) are not per se passive activities under IRC § 469(c)(2) but are treated as a trade or business and subject to the material participation requirements of IRC § 469(c)(1). Reg. § 1.469-9(e)(1)
- To qualify as a real estate professional, the tax payer must
- perform more than one-half of his or her personal services in real property trade or business, and
- perform more than 750 hours of services during the taxable year in real property or business in which the taxpayer materially participates. IRC § 469(c)(7)(B)
- The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. IRC § 469(c)(7)(C)
- An election is available to group all rental real estate as one activity. The election must be a written statement filed on an original return. Reg. § 1.469-9(g)
There are two very important aspects to consider when making your determination. First, the number of hours spent on real estate activities. Second, for taxpayers with multiple rentals, was an election filed to treat all rental properties as one? In an audit of your tax return, the IRS will focus on the following:
- Review if a company was hired to manage the rental on your behalf
- Review your log book of hours spent on real estate activities
- For taxpayers with multiple rentals, check if an election to treat all rentals as one activity was filed in the original tax return.
If you have a company that manages the day-to-day operations of your rental, your ability to meet the real estate professional rules becomes increasingly more difficult. You will have to prove that in addition to the activities of the company managing your property, you have logged in 750 hours managing the property as well. These hours should be documented by your log book. If you claim hours working with the company managing your property, the IRS will generally disallow those hours when determining if you meet the real estate professional rules. This disallowance may result in your rental activity being treated as a passive activity.
It is important to maintain a log book for all hours spent managing rental properties. Log books should be completed consistently every year. Do not wait until an IRS audit to develop your log book as the credibility of the log book will be questioned.
The 750 hours needed to be treated as a real estate professional applies to each rental property separately, unless an election is filed to treat all rental properties as one. Without the required election, you will need to have spent 750 hours on each rental individually. However, an election can be filed to treat all rental properties as one. As a result, you can meet the 750 hour requirement for all rentals combined.
The election to treat all rental properties as one must be filed at the time the tax return is filed. An election cannot be filed after the original return is filed. For example, the IRS will not accept an election filed with an amended return nor accept an election filed during a tax audit. The tax consequences for filing the election are complex and should be discussed with your C.P.A.
Seek consultation from a C.P.A. for help if you are considering identifying yourself as a real estate professional for tax purposes. If you are being audited and need assistance related to rental real estate, call ALG Tax Solutions at 855-MI-TaxHelp. (855-648-2943)
IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.