If you invest in real estate, most of your transactions are considered passive activities for income tax purposes. Therefore, the income earned from these transactions is treated as passive income. In the unfortunate circumstance that you realize an excessive loss, some, or all of it can be offset by income earned from these real estate activities or other passive income.
Generally, if you earn $100,000 or less annually, up to $25,000 of excess rental losses can be used to offset your income. Taxpayers earning between $100,000 and $150,000 can use a portion of their excess losses to offset income and people who make more than $150,000 typically cannot use any passive losses to offset income. Instead, these losses can be carried forward to offset rental income or capital gains on the rental property in future years.
According to the IRS, rental activities are passive activities even if you materially participated in them unless you qualify as a real estate professional. In this case, real estate activities, as well as any income generated or losses incurred, would be treated as non-passive.
You do not have to be a licensed real estate agent to be considered as a real estate professional for tax purposes. But you must meet both of the following requirements:
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Generally, you are considered to have materially participated in a real estate investment activity if you were continuously, regularly, and substantially involved in its operation during the tax year in question. Both real estate professional qualification requirements require material participation.
You cannot include personal services you performed as an employee in real property trades or businesses unless you own 5% of your employer's outstanding stock, outstanding voting stock, or capital or profits interest.
In addition, if you file a joint return, you cannot count your spouse's personal services to determine if you qualify as a real estate professional. However, you can count your spouse's participation in an activity in to determine if you materially participated.
A real property trade or business is broadly defined to include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. A facts and circumstances test applies in determining the taxpayer's real property trades and businesses. Any reasonable method may be used in applying that test.
A closely held corporation can qualify as a real estate professional if more than 50% of the gross receipts for its tax year came from real property trades or businesses in which it materially participated.
A taxpayer who is a real estate professional with total net income of $175,000 and net rental losses of $75,000, can offset their income with the losses to bring their Adjusted Gross Income (AGI) down to $100,000. On the other hand, if this individual is not a real estate professional, then their taxable income would remain at $175,000 for the year. As you can see there are definite advantages to being considered as a real estate professional for tax purposes.
To take losses from a rental property, the taxpayer needs to materially participate in the activity. We will discuss the material participation rules in a future alert.
Feel free to call us at 610.828.1900 if you have questions or want to learn more about the tax advantages of qualifying as a real estate professional. Contact either Michael Sexton, CPA, CCIFP, Director – Tax Services at
or me at
. We are always happy to help.