Deducting Real Estate Losses from nonpassive Income
Owning Real Estate comes with many tax saving opportunities. However, the IRS has Three different ways in which it categorizes real estate owners: Active Participant, Material Participant, & Real Estate Professional.
Being an Active Participant means that you own at least 10% of a rental property and have made some type of managerial decisions in a significant and bona fide sense. Managerial decisions in this case would include the approval of new tenants, deciding on rental terms, approving expenditures, and similar decisions. If you meet the qualifications of an Active Participant, then you are able to use the deduct up to $25,000 of passive losses from nonpassive income.
Another way to reduce property losses would be to become a Material Participant. A Material Participant is involved in an activity on a regular and substantial basis. You must also meet at least one of seven Material Participation Tests:
1. Has worked on the activity for more than 500 hours/year
2. Individuals participation in the activity is substantially all of the participation in the activity for all individuals in the year, including that of those who did NOT own interest in the activity.
3. Participated in the activity for more than 100 hours and the individual’s participation is at least as much as any other individual during the year
4. Activity is a “Significant Participation Activity” for the year (more than 100 hours per activity – 500 hours in total)
5. Has Materially participated in an activity for 5/10 years (does not have to be consecutive)
6. Activity is a personal service and individual has materially participated for 3 years.
7. Based on facts & circumstances, individual participated on a regular, continuous, and substantial basis. This test not applicable if <100 hours during the year. This test not applicable if someone other than the individual received compensation for managing the property or worked on the property for more hours.
If you meet any of the Material Participation Test, then you are able to deduct any amount of property losses on their tax returns. But, if you don’t meet any of these tests, then the IRS would consider you an Active Participant.
Another category that would allow you to deduct any amount of property losses would be becoming a Real Estate Professional. A Real Estate Professional must perform more than half of personal services in Real Property Trades, in which you materially Participated. You must also perform more than 750 hours of service throughout the year in Real Property Trades. In this case, Real Property Trades would Include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. However, you must not count any personal services that you performed as an employee, unless you owned more than 5% of the property.
Disclosure: The above is not to be taken as tax advice, rather as information only. If you would like us to consider your personal situation and help in determining your real estate taxes/ passive loss considerations, please contact us at firstname.lastname@example.org.
Writer: Bryan Alvarado, Staff Accountant