Real estate agents and investors can get a huge benefit in the tax code when it comes to deducting passive losses, but many of my real estate professional clients get confused in the language. It certainly is no surprise, as the IRS code makes it about as confusing as anyone could think to write it. With lengthy and complex language, how do you know the passive loss deduction applies to you?
The truth is that the code is complex when it comes to qualifying as a real estate professional for material participation. However, I’m here to help simplify the complexities and shine some light on how it applies to the vast majority of my real estate agent and investor clients. With some personal examples, you should have a better understanding of how you might be able apply this benefit to your situation.
Of course, you should always consult with your CPA and work with a CERTIFIED FINANCIAL PLANNER™ to know if you can qualify for material participation rules. If you don’t currently have a CERTIFIED FINANCIAL PLANNER™, I work with real estate professionals across the country and would be happy to provide a complimentary phone or Zoom consultation.
A taxpayer can pass by the assumption that all rental activities are passive, as long as the taxpayer can qualify as a real estate professional through satisfying two tests:
1. More than 50% of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
2. The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
Okay, so far the majority of real estate agents and investors would qualify for this definition and they are on their way to being able to write of rental losses as a deduction. However, the IRS continues to further define material participation. This is where the coding becomes quite confusing.
A taxpayer qualifies and materially participates in a real estate business or property if that taxpayer can satisfy one of seven of the following tests:
1.Participation for more than 500 hours.
2. Activity that constituted all participation substantially.
3. Involvement for more than 100 hours and no less than the participation of any other individual.
4. Which is a significant participation activity, combined with all significant participation activities, for more than 500 hours. A significant participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
5. Participation during any five of the preceding ten taxable years.
6. Which is a personal service activity for any three prior taxable years. Personal service activities are activities in which capital is not a material income-producing factor, such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
7. Partaking for more than 100 hours and based on all the facts and circumstances, on a regular, continuous, and substantial basis.
If the seven rules didn’t just thoroughly confuse you, then you are a quick study and deserve a pat on the back. For the rest of us, I want to provide a couple of examples that will lift the clouds and give you all some needed clarity.
Danielle owns her own real estate office as a 5% owner or more. Over the last 10 years as a real estate agent broker, she has accumulated a few residential rental properties. Each year, she is responsible for finding the tenants, collecting rent and overseeing the maintenance of the properties. This year, Danielle has $45,000 of rental losses due to some major repairs on the properties. However, she did have a good year in her real estate sales and produced $550,000 in net income. Because she materially participates in the property and qualifies for the definition of a real estate professional, Danielle can deduct the $45,000 in full against her income.
Randy purchases forgotten and old properties to fix up. He usually will hire a 3rd party contractor and builder to renovate each of the properties for resale. As an LLC, Randy will file a schedule C for all of his real estate endeavors, as it is his main source of income. In addition, he also owns 2 residential rental properties that are also older homes that generate about $20,000 in losses each year. As an informed real estate professional, he fully manages the rentals by himself. Because of this, Randy materially participates in the real estate activities, qualifies as a real estate professional, and can fully deduct the $20,000 in losses for this year against his professional income.
As you can see from these examples, most real estate professionals might be able to fit into the material participation rules to receive the full benefit. The IRS code can be extremely confusing and lead to not taking advantage a very advantageous situation for your taxes. However, I’m here to break it down to something a little less intimidating. Almost all of my real estate professional clients can take advantage of the material participation rules and use to their advantage in years where income taxation is higher than others.
If you need further help in your unique situation, I’m here to help walk you through it. Don’t hesitate to call my office if need some strategic help with your financial planning.
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The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
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