For those with rental income that produces an overall loss, it can be frustrating to find out from their accountant that the IRS may prevent them from using the loss for their benefit on their taxes. However, for eligible taxpayers, there are strategies they can take advantage of to overcome these restrictions. Read on for more details.
Under the default Passive Activity Loss (PAL) rule, it prevents taxpayers from deducting any expenses that are generated by passive activities in excess of the income from those activities. In other words, you can’t deduct the losses against other nonpassive income, which can be unfavorable to a taxpayer. However, there are exceptions that could nevertheless allow such loss to be claimed against ordinary income. Unfortunately, it is not an easy matter of just listing out the exceptions and their requirements, because the rules for each can sometimes intertwine with one another. For the sake of simplicity, we will take into consideration a taxpayer that is a sole proprietor with a disregarded entity that reports through Form 1040 (e.g., Schedule C, E, F).
So, in order to overcome the default passive loss limitation, a taxpayer must be seen as “materially participating” in the activity (aka the “500 hour” standard) where they can use a special rule to group all their activities as an “economic unit” (see, Treas. Reg. 1.468-4) in order to meet its requirement totals. The problem with this exception is that it technically kicks out anything to do with rental activity, meaning regardless of how many hours the taxpayer may materially participate, they typically cannot use the exception. Despite this, the Code has carved out two deviations (exceptions to the exception).
- The “$25,000” exception; or
- The “real estate professional” exception.
The $25,000 exception allows a taxpayer to claim $25,000 of losses from the taxpayer’s otherwise passive rental real estate activities against ordinary income if the taxpayer is deemed to have “actively participated” in the activities (the meaning is different from “material participation”, as it is less stringent) and if the taxpayer’s adjusted gross income is not over a certain threshold. See IRS Publication 925 for full details on the $25,000 exception.
The real estate professional exception allows the rental real estate activity to not automatically* be treated as passive. Without going too into the weeds, in order to be seen as a “real estate professional” for purposes of this exception, here are the basic requirements:
- The taxpayer must have materially participated (i.e., involved in the operations of the activity on a regular, continuous, and substantial basis; see list of tests in Publication 925) in a real estate business (renting, leasing, etc.).
- More than 50% of the personal services the taxpayer performed in all businesses during the year must have been performed in real estate businesses in which they were considered to materially participate.
- The taxpayer’s personal services in material participation during the year must have amounted to more than 750 hours (i.e., can’t count any work performed in their capacity as an investor).
As such, for those that are deemed real estate professionals, losses from those activities can be deducted against ordinary income if the taxpayer is considered to have “materially participated” in said activities (the term “materially participated” here is an example of how provisions can seem to cross-reference one another and create confusion, where the meaning in this case refers to different perimeters that must be met (aka “750 hour” / “more than 50%” standards). Furthermore, the real estate professional exception has its own special grouping rule that can help meet its requirement totals under Treas. Reg. 1.468-9 (not to be confused with the grouping rule under Treas. Reg. 1.468-4 for the exception above).
In a nutshell, those with rental activity cannot generally use the main exception, but they can try and fall under the $25,000 exception or the real estate professional exception. Please contact us to discuss whether an exception might apply.
* Even though a taxpayer may qualify as a real estate professional and their rental real estate properties are not automatically treated as passive – this does not mean that they are automatically treated as nonpassive. Instead, it means that, if the taxpayer materially participates (as defined by Sec. 469(c)(7)) in the operation of rental real estate property, then it will be treated as nonpassive. In addition, if the taxpayer has multiple properties, the taxpayer may not be able to qualify as a real estate professional unless they elect to treat all their rental real estate interests as a single activity. If the election is made, it applies both for purposes of qualifying the taxpayer as a real estate professional, and for all other purposes of the PAL rules (and the election is normally irrevocable). Making the election will also disqualify the taxpayer from utilizing the $25,000 active participation exception mentioned above, because that rule applies only with respect to losses from rental real estate activities that are passive, and as a result, the election works to make the rental real estate activity nonpassive.
NOTE: The real estate professional exception applies on a yearly basis, so whether the requirements are met must be evaluated every tax year. It is possible to claim a late election for purposes of the real estate professional exception concerning its specific grouping rule (i.e., Treas. Reg. 1.468-9) as the IRS has provided relief through Rev. Proc. 2011-34.
