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Real Estate Professional Defined
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Real Estate Professional Defined
Why designate myself as a real estate professional? Aside from being something cool to tell the grand kids, let’s presume that you have a rental loss. It is common to have a tax loss on your rental although it cash flows, and the primary reason is depreciation. How does it affect your tax return?
Section 469 defines a passive activity as any activity that involves a trade or business in which an individual taxpayer does not materially participate. Rental income is typically considered passive, meaning that you are not directly earning the income as you would with a W-2 job or as a small business owner. Passive losses may be deducted from passive income, and from non-passive income such as wages and business income but there are limits (of course there are!). Passive loss limits for married taxpayers max out at $25,000, and that number decreases as your gross income increases.
Specifically, passive loss reduces $1 for every $2 over $100,000 adjusted gross income (AGI) and by $150,000 (for married couples) the passive loss deduction is $0. Bummer. Not all is lost however. If your rental losses are capped or disallowed because of passive loss limits, the portion exceeding the passive loss limit is carried forward on Form 8582, aggregated for each year and may be deducted in the year of disposal (sale). They may also offset future net rental income… you had losses, they were carried forward, you now have rental profits and the suspended losses can be used to offset.
Passive loss limits for single filers or for married persons who live apart for the entire tax year is $12,500. If you live with your spouse for any part of the year yet file a married, filing separate tax return the passive loss limit is $0. Not good.
There is another angle to all this, and this is the gist of this article- if you are a real estate professional as defined by the IRS, you can deduct 100% of your rental property losses and you are not capped by passive loss limits. This makes sense since your rental income is no longer passive if it is your livelihood or at least a large portion of your livelihood. In other words, the real estate professional (REP) status is essentially telling the IRS and the world that your rental activities are not something you tend to from time to time but rather are approached with the mindset of a busy business owner.
But wait! There’s more. As mentioned later in this post, when the Net Investment Income Tax (NIIT) which was introduced along with the Affordable Care Act, the real estate professional designation became an important tax planning tool all over again. Huh? If your modified adjusted gross income (MAGI) hits a certain amount, the NIIT is charged on all portfolio (interest, dividends, capital gains) and passive activity income (rentals). However, if you are a real estate professional your taxable rental income (profits) is no longer deemed passive and as such is not being taxed by the net investment income tax of 3.8%. That could be huge!
So, how do you become a real estate professional? It is not enough to simply own rentals or have a real estate license. There is a two part test… hours spent and material participation-
- Spend 750 hours on real estate activities (more than other activities such as your day job), and
- Materially participate as defined by Section 469-5T
Let’s do this!
Real Estate Professional Hours
Taxpayers are required under Internal Revenue Code Section 1.469-5T(f)(4) to provide proof of services performed and the hours attributable to those services. Here is a snippet regarding proof for material participation, and the same process can be used for substantiating real estate professional hours-
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
Second, logs cannot be retro-created. So, you must have been maintaining your logs as you performed the real estate activities. During an audit or examination if you mention things like “I jotted activities down on my log and then went back and tallied the hours in preparation for this audit” you will probably lose. You need to have maintained the written account of your hours from the beginning. Here is the case law reference- The regulations do not allow a postevent “ballpark guesstimate” in Moss v. Commissioner, 135 T.C. 365, 369 (2010).
Third, on-call hours do not count, you must “perform” an activity. The tax court has ruled that waiting for the phone to ring in case a maintenance or emergency call comes in does not count. Here’s the snippet from Kutney v. Commissioner, Tax Court Summary 2012-20 under footnote 7-
Petitioners also contend that Mr. Kutney’s ownership and management of the rental properties was a “truly full day activity” that required him to be available all day every day and that these on-call hours should count towards the 750-hour requirement. We disagree with this contention. Sec. 469(c)(7) applies where the taxpayer “performs more than 750 hours of services” rather than where the taxpayer is merely on call to perform services. Sec. 469(c)(7)(B)(ii); see also Moss v. Commissioner, 135 T.C. 365, 370 (2010); sec. 1.469-9(b)(4), Income Tax Regs.
Ok… that is hours and which ones count, etc. Let’s move on to material participation.
Material Participation
Let’s discuss active participation first. For rental properties, the issue is nearly moot since active participation relates only to rental real estate activities and is a less stringent standard than material participation. As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. Activities include new tenant approval, rental terms, repair authorizations, capital expenditures, etc. WCG CPAs & Advisors has a client whose brother handles all of the rental property matters for a condo in San Francisco- in this example, his participation did not reach the level of active participation. Said differently, if you forget that you own a rental, you likely do not actively participate.
According to the IRS Audit Techniques Guide on Passive Activities there is not a specific hour requirement. Even if you use a management company, you will be considered active if you are involved with the operation of your rental. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager or management company. In addition, the taxpayer must have at least a 10% interest in the rental activity.
To recap for married taxpayers, passive activities such a rentals or investment partnerships have a loss limit of $25,000 in offsetting non-passive income such as W-2 wages or other earnings. This is reduced $1 for every $2 over $100,000 in adjusted gross income. Any disallowed passive loss is carried forward until you dispose of the property or investment. For example, you make $120,000 at your regular job and have $30,000 in rental losses. Your passive loss deduction is $15,000 ($25,000 minus $10,000) and the remaining $15,000 is carried forward.
So active participation only matters for those taxpayers who are not limited on their passive losses. In other words, if you do not exceed the passive loss limits you only need to demonstrate active participation. However, and the primary purpose of this article, to avoid the passive loss limitations of $25,000, a taxpayer must be considered a real estate professional who also materially participates in the rental activity.
Don’t forget the reduction of net investment income tax by changing the color of money on your rental activities from passive to something other than passive. The rules for material participation are considerably more stringent, and will be discussed next. Fun!
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