Rental Property Loss Deductions

Ten Forty + Quality Tax Preparation & Financial Services 281-397-7777 Fax 281-397-7443 Tax Tip Rental Property Loss Deductions The IRS Chief Counsel’s Office sets forth a clear and easier path to rental property deductions. Let’s start with the big picture and why you want to learn the IRS method. Your rental property deductions face a basic rule: all your rental real estate activities are automatically passive activities unless you pass a test that makes you a “qualifying individual,” known in most tax publications as a “real estate professional.” Rental property losses become automatically passive if you are not a real estate professional and you have Adjusted Gross Income (AGI) $125,000 or higher. Once you reach qualifying individual (real estate professional) status, your rentals become business properties that escape the passive loss rules, and they become tax shelters when you materially participate in the properties. That’s the big picture. Now, let’s see how the IRS’s clear and easier path to real estate professional status eliminates the muddle and leads to tax deductions. Tax law treats renting real estate as a passive activity regardless of the amount of time you spend on the activity. In the ugly passive loss trap, you may not use passive losses to offset taxable income from nonpassive sources (such as business or investment income). The tax code contains an important escape from the automatic rental property passive loss trap for qualifying individuals (real estate professionals): a real estate professional may currently deduct rental real estate losses if he or she materially participates in the rental activity. To qualify as a real estate professional, you must meet two time requirements: 1. You must spend more than 50 percent of your time in real estate activities in which you materially participate. 2. You must spend more than 750 hours in real estate activities in which you materially participate. Real estate activities include real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, management or operation, leasing, and brokerage. The hours you work as an employee in real estate activities do not count toward the two time tests unless you are also at least a 5 percent owner. The IRS, in Chief Counsel Advice 201427016, clarified how you should apply the hourly and material participation rules.8 Here’s how this clear advice works—and we’ll explain it as the IRS did, with the IRS example. Example facts. You own a real property development business, rental property 1, and rental property 2. You provide more than 750 hours of personal services in the three activities combined, and you provide zero personal services for other trades or businesses. According to the IRS, you pass both tests, and that makes you a real estate professional. Because of this enhanced tax status, you now treat the two rentals as businesses (Note that the IRS required no grouping election of any type for you to achieve real professional status. Further, the IRS said that you materially participated in the combined activities because you passed the more­than­500hours test for material participation.). Get ready. You are about to see how easy the IRS makes it to materially participate and achieve tax deduction status for the rentals. To deduct a business loss from one or both of the rentals against income from all sources, you must materially participate in the individual rental or group of rentals (if formally grouped, the two rentals are treated as one for the material participation tests). To materially participate, you need to meet only one of the following five tests for either the individual rentals or the group of rentals (if grouped): 1. You perform more than 500 hours of service. 2. You perform substantially all the services performed in the activities (as compared with services performed by others, including employees or outside contractors). 3. You perform more than 100 hours of service and perform more services than any other person. 4. You met the material participation test for any five out of the past 10 years. 5. You participate in the activity on a regular, continuous, and substantial basis, based on the facts and circumstances. For purposes of the material participation test, you treat each of the two rentals as a separate activity, unless you make or have made a grouping election in your tax return to treat all your rentals as a single, collective activity. In the Chief Counsel Advice, the IRS automatically grouped (a) rental property 1, (b) rental property 2, and (c) the real property development business. You did not need to make an election in your tax return to put these three activities into a group for the more ­than ­50 ­percent and more ­than ­750 ­hours tests. Not having to materially participate in an individual property for it to qualify for both the more­ than ­50­ percent and the more ­than ­750 ­hours rules is a big deal. Many taxpayers, tax professionals, and IRS examiners have misapplied the material participation rule to deny professional real estate status. If you are one of those who got real estate status wrong but materially participated in the property or group of properties, give us a call, we can help you file an amended tax return and apply those losses against your other income to produce a tax refund. Tax season is here. Go to www.tenfortyplus.com and complete your online organizer (under forms and documents). Make your appointment using our online appointment system. Call 281-397-7777 and get a user id with password set up so you Regards, Joseph C Becker EA www.tenfortyplus.com 281-397-7777, Fax 281-397-7443 joeb@tenfortyplus.com Contact Us There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following: • Pension or IRA distributions. • Retirement. • Significant change in income or • Notice from IRS or other deductions. Revenue department. • Job change. • Divorce or separation. • Marriage. • Self-employment. • Attainment of age 59½ or 70½. • Charitable contributions • Sale/purchase of a business property in excess of $5,000 • Sale or purchase of a residence or other real estate.