Real Estate Losses: Complex Rules Determine Deductibility

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The American economy is certainly on the brink of a crisis, fueled in large part by the real estate meltdown. The Florida market is clearly the front-runner in the sub-prime loan frenzy that attracted investors from all over the world to buy everything from land– to houses– to the “infamous” condominiums.

Most of you who are grappling with this crisis have two important questions in mind: 1) How can I sell my investment property in this market? and 2) How can I reap tax benefits of the losses I have or will suffer from selling or leasing my property?

Though the sale of your property is certainly beyond the scope of our expertise, we believe a good realtor and some good luck will do the trick. What is our expertise are the tax laws and regulations pertaining to rental real estate investments.

The most important set of rules in the area of real estate are the passive activity rules. These rules limit losses to the extent of passive income. In other words, losses resulting from passive activities (activities in which you do not “materially participate”) cannot be deducted against “active” or non-passive income (salary, interest, dividends, self employment income). Furthermore, credits from passive activities cannot be used to reduce taxes on non-passive activity income. Please note that rental real estate activities are considered “passive” by definition, even if the owner “materially participates” in their management. Thus, tax losses resulting from a rental can’t offset against non-passive income.

One important exception to the rule is the ability to deduct up to $25,000 of losses and credits from passive rental real estate activities against non-passive income, provided “active participation” conditions are met. “Active” participation requires a lesser degree of participation than “material” participation. This rule starts phasing out for taxpayers with modified adjusted gross incomes over $100,000 and completely phases out at $150,000.

If you make over $150,000 and wish to deduct passive real estate losses, the only way around it is to qualify as a “real estate professional.” If such is the case, then all your losses can offset your current active income without any limitations. Becoming a materially participating real estate professional goes well beyond giving yourself a fancy title of one. Section 469(c)(7) of the Internal Revenue Code establishes the following two-pronged stringent criteria:

  • More than 50% of the personal services performed in trades or businesses by the taxpayer during any particular tax year are performed in real property trades or businesses in which the taxpayer materially participates, AND
  • Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

The regulations to Section 469 further elaborate specific criteria for taxpayers to qualify as real estate professionals. The important caveat to remember in these regulations is the taxpayer’s successful ability to prove, based on facts and circumstances, that the material participation was “regular, continuous and substantial.”

For those who would qualify under these stringent tests, it is vitally important to remember to make a special election under Section 469(c)(7)(A) to group all interests in all real estate activities into a single activity. Absent the election, the above tests would apply to each real estate activity and make it practically impossible for the taxpayer to meet the material participation standard.

As with all business activities, it is not adequate to merely meet the IRS qualifying standards, but is equally important to be able to substantiate compliance to the regulations with good recordkeeping. Maintaining good financial records, documenting intentions in corporate record books, and segregating various properties into separate legal entities—are all good ways to maintain the “sanctity” of your tax positions.

Amol Nirgudkar, CPA is the managing partner of Reliance Consulting LLC can be reached at (813) 931-7258 or via email at amol@reliancecpa.com

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