Life isn’t exactly easy for most real estate brokers and agents these days. But real estate pros who own rental property have one thing going for them that others don’t: special tax advantages.
Let’s say that you are a rental property owner and you spend more on the property than you earn during the year–a depressingly common occurrence. Naturally, you’d like to be able to deduct your loss from any non-rental income you have, thereby reducing your taxable income and lowering your taxes for the year. Unfortunately, losses from real property rentals are classified as “passive activity losses.” Special passive activity loss rules greatly limit the amount of losses that a rental property owner can deduct from his other non-passive income, such as salary or other business income. A maximum of $25,000 can be deducted from non-passive income each year, and even this is phased out if the owner’s adjusted gross income exceeds $100,000. Unused losses must be saved for future years. For details, see our article “Limits on Deducting Rental Property Losses.”
Luckily for real estate professionals, they can qualify for a special exemption from the passive loss rules–an exemption nobody else can get. If you qualify, you may deduct any amount of rental activity losses you have for the year from your other income–such as real estate commission income–regardless of how high your income for the year may be. (IRC Sec. 469(c)(7).) For example, a real estate broker who loses $100,000 from his rentals could deduct the entire amount from his commission income.
But it gets even better. Real estate professionals are also not subject to the 3.8 percent net investment income tax on their real estate income. The NII tax was enacted to help fund Obamacare and took effect with the 2013 tax year. (However, real estate pros do have to pay the 3.8 percent tax on investment income, like interest and dividends.) So being a real estate professional can now save you on taxes whether your real estate ventures make or lose money.
Unfortunately, the rules for determining who qualifies for the real estate professional exemption from the passive loss rules are complex. You qualify for the exemption, and may treat all your losses from your rental properties as active losses, only if you satisfy all three of the following tests:
- 51 percent Test: You (or your spouse, if you file a joint return) spend more than half of your working hours during the year working in one or more real property businesses in which you materially participate
- 751-Hour Test: You (or your spouse, if you file a joint return) spend more than 751 hours a year in one or more real property businesses in which you materially participate
- Material Participation Test: You and your spouse materially participate in your rental activity.
For the first two tests, each spouse’s time is taken into account separately. Thus, one spouse alone must satisfy the 51 percent and 751-hour requirements. For the third test, both spouses’ time together is counted if they file a joint return. Usually, you’ll have no problem satisfying the first two tests, unless you only work part-time in real estate. It’s the material participation test that can cause big problems.
51 Percent Test
The exemption is for real estate professionals, so it makes sense that you (or your spouse) must spend more than half (51 percent) of your working hours during the year running a “real property trade or business.” Your working hours are the hours you spend personally working in a trade or business.
A real property trade or business includes any “real property brokerage business.” Any person who engages in one or more of the following activities is in the real estate brokerage business:
- Selling, exchanging, purchasing, renting or leasing real property offering to do the activities mentioned above negotiating the terms of real estate contracts listing real property for sale, lease, or exchange
- Or procuring prospective sellers, purchasers, lessors or lessees. It makes no difference whether a person who engaged in these activities is licensed as a real estate broker, agent or salesperson.
In addition, you cannot just be an employee in someone else’s real property business. You must own your own real property business or at least be a part owner, owning more than 5% of the business. If you work as an employee for a corporation, you must own more than 5% of your employer’s outstanding stock.
It’s not enough that you (or your spouse) spend more than half of your work time in a real property business. After all, if you had no other work, you’d spend more than half your work time on real estate if you spent only one hour a year on it. To avoid this result, you or your spouse is required to spend at least 751 hours per year working at your real property business or businesses. 751 hours amounts to only 14.5 hours a week. Again, if you work in more than one real property business, you may combine the time you spend on each.
Example: John is a part-time real estate agent who also owns several rental properties He worked 200 hours per year on his rental properties and 601 hours as a real estate broker. By combining both these real estate business activities, John exceeds the 751-hour limit.
Material Participation Test
You must “materially participate” in your rental activity to qualify for the exemption. This requires that you work a certain number of hours at your rental activity during the year. For example, you would materially participate if you work at least 500 hours during the year at the activity. You can qualify in other ways as well:
- You did substantially all the work test: You substantially performed all the work in the activity during the year
- 101-hour test: You participated in the business for more than 100 hours during the year, and you participated at least as much as any other person
- Combo test: You participated in two or more businesses between 100 to 500 hours so that the total hours are more than 500
- Past performance test: You materially participated in the business for any five of the last ten years
- Facts and circumstances test: The facts and circumstances show that you materially participated.
If you own more than one rental property, here’s a key point to understand: You are required to materially participate for each rental property you own unless you file an election with the IRS to treat all your properties together one, single activity. This way, you can combine the time you spend working on each rental property to satisfy the material participation test. If you fail to file the election, you’ll have to materially participate for each rental property you own. For most landlords, this is impossible to do, which makes filing a timely election very important.
Example: Dennis owns five rental homes. He works 500 hours a year managing all five, and no one else does any work on the properties. If he files an election with his tax return to treat all his properties as one rental activity, he’ll pass the 500-hour material participation test. However, if he fails to file the election, he’ll have to materially participate for each house he owns—that is, he’d have to work 500 hours on each house, instead of all five together.
To make an election to treat all your rental activities as one activity, you’ll need to draft a statement like the following and attach it to your tax return:
Tax Year:__________ Taxpayer Name:___________
Taxpayer Identification Number: _______________
In accordance with Regulation 1.469-9(g)(3), taxpayer states that he/she is a qualifying real estate professional, and elects under IRC Section 469(c)(7)(A) to treat all interests in real estate as a single rental real estate activity.
The election can be filed any year you qualify for the real estate professional exemption and only needs to be filed once, it applies to all future years that you qualify for the exemption. It may only be revoked if you have a “material change” in circumstances. The fact that the election is less advantageous to you in a particular year is not a material change in circumstances. (IRS Reg. 1.469-9(g).)
Good Records are Key
If you are audited by the IRS, the key to preserving your real estate professional exemption is good records of your annual work hours. IRS regulations provide that you may use any “reasonable means” to keep track of your work time, including daily time reports, logs, appointment books, calendars or narrative summaries. (IRS Reg. 1.469-5T(f)(4).) You are not absolutely required to keep contemporaneous records–that is, records made at or near the time you did the work involved–but it is a good practice to do so.
MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.