Many of my clients are investing in real estate, but most don’t understand the tax rules that go along with the investment. The motivation for making this investment varies, but for the most part, it’s appreciation and cash flow.
A real estate investment can be as simple as a vacation home or rental property. Rental property can be, for example, a multi-family dwelling or a property that’s rented to the taxpayer’s business (there are separate rules for this not discussed in this column).
Before going any further, there’s one basic rule that must be understood. For the most part, a trade or business that the taxpayer doesn’t materially participate in is considered a “passive activity.” This means that the taxpayer may not deduct passive activity losses against non-passive activity income. Assume a PR professional operates a small PR agency that earns $200,000. The same PR professional also invested in another business that he or she does not actively participate in. This business lost $200,000. This loss of $200,000 cannot offset the income earned by the active business. Therefore, the loss is suspended!
Unfortunately, rental real estate activities are considered passive activities, even if the property owner does materially participate in the rental activity. (There are exceptions to this rule however.) Therefore, the real estate loss cannot offset the income earned by the PR agency.
Passive activity income and losses
It matters not how real estate is owned. You can purchase property directly or make an investment in an S corporation, partnership or limited liability company. If the real estate activities generate operating income, this income is taxed as ordinary income. If the activities generate a loss, these loses must clear three hurdles before it can be deducted: tax basis, at-risk and passive loss limits.
Without getting into too much detail, the tax basis hurdle is simple: it limits the loss deduction to your tax basis in the property. Therefore, if you purchase real estate for $2.0 million free and clear your tax basis is $2.0 million.
If, on the other hand, you purchase the same property for $2.0 million and secure a $1.5 million mortgage, you need to clear the at-risk rule. Your tax basis is still $2.0 million assuming you’re at-risk for the mortgage. Therefore, if the property generates a $100,000 loss, you have the potential to deduct the $100,000 loss. If, on the other hand, the loan to purchase the property is non-recourse, you have no economic risk other than for the $500,000 down payment. Once you get by these two hurdles, the passive activity loss rules must be satisfied as discussed above. Remembering that real estate activities are considered “passive” not active activities, a taxpayer must pass one of a series of tests to be considered materially participating in the activity. If you make a direct investment in real estate the material participation requirement is simple to pass. If you are one of 50 other investors in a real estate partnership, the likelihood is you will not pass the material participation requirement.
Accordingly, if your share of the real estate activity loss is $50,000, you will not be able to deduct this loss unless you have other passive activates that generate passive income. There’s an exception to this rule in the year you sell or otherwise dispose of the property and that’s not discussed in this column.
Rental real estate exception
Small landlords with modified adjusted gross income under $150,000 ($75,000 if married filing separately) will be able to deduct the loss against non-passive sources of income. Under this exception, you can deduct up to $25,000 of rental losses from your non-passive income, such as wages, dividends and interest. If your Modified Adjusted Gross Income exceeds $100,000 ($50,000 for married filing separately) the $25,000 deduction ($12,500 for married filing separately) is reduced by 50 percent of each dollar over $100,000. ($50,000 for married filing separately). Once your MAGI reaches $150,000, the $25,000 deduction is eliminated.
Real estate professionals
Let’s say you are year employed or own a PR agency. Let’s further assume your average work year is 2,000 hours, and you also work 752 hours managing your properties. Over the years, you’ve purchased real estate and now you own and manage six properties. You’re familiar with the tax rules concerning real estate. However, a friend told you that you’re a “real estate professional” and the passive activity loss rules don’t apply to you. You make an appointment with your tax advisor and ask why you were never considered a real estate professional?
The simple answer is you just do not qualify! True, income and losses arising from any rental activity are generally considered passive. One exception to this rule applies to real estate professionals. If you qualify as a real estate professional, the rental real estate activity escapes the per se rule otherwise applicable to a rental activity.
So, can a PR professional qualify as a real estate professional? It’s difficult and, yes, maybe even impossible!
To be a real estate professional, a PR pro must provide more than one-half of his or her total professional services in real property trades or business in which he or she materially participates and performs more than 750 hours of services during the tax year in real property trade or businesses. For purposes of determining if you’re a real estate professional, your material participation is determined separately for each property unless an election is made to treat all interests as a single rental activity.
Getting to the math. Our PR pro worked 752 hours and passed the more than 750-hour test. However, 2,000 hours plus 752 hours is 2,752 hours divided by two is 1,376 hours. Our PR professional worked 752 and therefore failed the test. Play with the numbers; unless your primary business is real estate, it’s extremely difficult to pass this test.
Richard Goldstein is a partner at Buchbinder Tunick & Company LLP, New York, Certified Public Accountants.