By Rochelle Moore, Principal
You have investments in real estate because let's face it, it's one of the few investment options that can generally withstand the test of time. But real estate is expensive and not liquid, so it's important to maximize the tax benefits on your investment and keep cash in your pocket instead of the government's! Being a real estate professional can be a way to accomplish this goal.
Why would you want to be a real estate professional?
Rental real estate entities generally generate losses, particularly when the initial building placed in service is still being depreciated. Additionally, rental real estate losses are generally considered passive, meaning that in order to utilize your rental losses, you must overcome both basis and passive loss limitations. So, what does this mean for the taxpayer? In short, you can only take passive losses to offset passive income, which is not the desired answer for most.
There is an opportunity to utilize $25k of rental real estate losses a year regardless if there is passive income to offset. This is great news for those who do not have enough passive activity income to offset their passive losses. Of course, there are some limitations associated with such a deduction. For those individuals with a modified adjusted gross income (AGI) of $100k or less (before your rental losses), you can deduct up to $25k in real estate losses. Unfortunately, for those individuals with modified AGI over $100k, this loss is phased out dollar for dollar until you reach a modified AGI of $125k, regardless if you are filing single or married filing jointly. Oh, and don't get any ideas about filing separate from your spouse to fall under the modified AGI limitations, because you won't even qualify for this deduction using married filing separate!
The depreciable life of a building ranges from 27.5 to 39 years, which is a long time to get a deduction for your investment, especially if you cannot even take the loss it created! Let's face it; significant improvements will be needed down the line. This means more cash outflow and potentially no deduction for that either! Don't you want to utilize those deductions with upfront expensing methods such as Section 179 or bonus depreciation?
Let’s flip the scenario. Say you consistently have rental income every year. Remember that 3.8% net investment income tax implemented back in 2013? Well, your rental income will be subject to an additional 3.8% of tax because passive rental income is considered investment income! Probably not the answer you were looking for, right?
So where do we go from here? Everything so far seems like reasons to scare you off from keeping your investments in real estate, but, that’s not the point of this article. The point is that everything we have discussed so far are all the reasons why you WANT to be a real estate professional.
Let's summarize more clearly how being a real estate professional fixes the issues we’ve discussed:
- As a real estate professional, you will be able to treat all your real estate activities in which you materially participate in as non-passive, meaning that you will be bypassing those pesky passive loss rules!
- You have rental losses over $25k and modified AGI over $125k. Great news! The $25k rental loss limitations no longer apply to you!
- Your real estate related activities are now considered trade or business income and no longer subject to that awful additional 3.8% net investment income tax!
How do I qualify as a real estate professional?
There are two significant requirements you must fulfill to be a real estate professional:
- First, you must perform more than 50 percent of your services in real property and trades or business activities you materially participate in.
- Second, you must log 750 hours or more during the tax year in the same real property trades or businesses in which you materially participate in.
It seems simple, but there is a lot to these requirements.
First, what is a real property trade or business? The list isn't as short as you would think. A real property trade or business can include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerage. Pretty inclusive list, right?
The second part of this first requirement is probably the most cumbersome to address: the "materially participate" requirement. In order to meet this requirement, the taxpayer and/or spouse should fulfill one of the requirements for each real property trade or business under IRC §1.469-5T(a)(1)-(7) in that tax year. The most common requirement used for substantiation of material participation is working more than 500 hours in the real property trade or business. However, there are six other viable options to substantiating your material participation in your real estate trades or businesses.
Now, let’s look at that greater than 50 percent requirement. If you have a job outside of the real property trades or business that takes up a substantial amount of your time, you may have hit a road block. For instance, if your work week consists of a normal 9 a.m. to 5 p.m. job and you log 40 hours behind a desk, you may need to work an additional 40 hours on top of that at your real property trade or business in order to qualify. Talk about burning the candle at both ends! Not only is this unrealistic, but it’s also much more difficult to prove to the IRS.
Material participation hurdles
As mentioned above, material participation plays a huge role in determining not only whether you are a real estate professional, but also what activities qualify under your real estate professional treatment. Once you have determined you are a real estate professional, you must then determine if you materially participate in each individual real estate trade or business before treating each activity as non-passive. As such, there are two levels of material participation hurdles that must be overcome; one to prove you are a real estate professional and another to prove material participation in each individual real property trade or business.
Remember when we explained how it doesn’t matter whether you are single or married on the $25K rental loss exemption? Well, that's not the case when determining whether you are considered a real estate professional. A taxpayer and their spouse may be considered as a real estate professional together, regardless if they file a joint return. Perfect, right?
When fulfilling the real estate professional requirements, one spouse must meet both the 50 percent and the 750-hour test individually in a real estate trade or business in which they materially participate in. However, when determining what real estate trade or businesses there is material participation in, both the taxpayer's and spouse's hours in that business activity can be combined. Grouping various activities together could help a taxpayer fulfill material participation tests that they may not have otherwise fulfilled in each individual real estate trade or business. For instance, if you have three activities grouped together and you worked a total of 550 hours collectively between all the activities, you would fulfill the 500-hour material participation requirement.
Some ways you may be able to group certain activities are as follows:
- Real estate trades or businesses may be grouped together with the exception of rental real estate activities. When utilizing this grouping election there is an opportunity to pick and choose what activities are grouped together.
- A taxpayer may elect to treat all interest in rental real estate as one activity, which is an all or nothing grouping.
- A taxpayer may elect to group a rental real estate with a non-rental real estate activity assuming the activities are related and considered an economic unit. The rental activity must also be insubstantial to the business activity or each owner in the business have the same proportionate ownership interest in the rental activity. Some factors to consider when determining if the trades or businesses are considered an economic unit are business similarities, common control, common interest, geographic location, interdependence of activities, centralized business functions, etc.
It’s important to note that any grouping election made is effective beginning in the year made and all future years, even if your status as a real estate professional changes. The only time you may change the groupings is in a year in which there is a material change in circumstances. As such, you should be cognizant of any suspended passive losses a taxpayer may currently have, like if an activity which was previously considered passive had losses which you were unable to use, then there would be suspended passive losses. Generally, when you dispose of that activity, all previously suspended losses would be released and offset any income generated in the year of disposition. However, if you were to group this activity with other activities, any suspended passive losses would remain suspended until all or substantially all activities in the group are sold.
In addition, if the election is made and 10 percent or more of the taxpayer’s share of gross receipts from rental real estate activities comes from limited partnership interests, the combined activity is treated as a limited partnership interest and is subject to the limited partner material participation tests (an entirely different issue).
What else do you need to know?
There’s a common misconception that that real estate professional status is something you elect, which is not the case. You either are or are not a real estate professional. You may be considered a real estate professional in one year and not in another, and since this is a year-by-year test, you must document and fulfill the requirements every year. Therefore, you could potentially generate passive and non-passive income and losses from the same real estate trades or businesses in different years. So, this is a great time to make sure you understand your suspended loss carryovers when tax planning.
Lastly, it is crucial that you substantiate your material participation through detailed recordkeeping. Documenting your time spent on each business can include, but is not limited to appointment books, calendars, daily logs, etc. You should be recording your tasks, on what entity, when it was performed, how much time you spent doing that task, etc., and your records should be maintained as you do them rather than retroactively. Failure to substantiate material participation is one of the easiest ways for the IRS to challenge whether a rental trade or business, specifically a rental real estate activity, is non-passive. This goes for determining your real estate professional status too!
Make sure you are navigating the real estate professional requirements and material participation laws in the most tax efficient manner. Reach out to The Bonadio Group's real estate experts today to learn more.