One thing I know is a lot of realtors! Tony Nitti just wrote a fantastic Forbes article that delves deep into the tax treatment known as a qualifying real estate professional. His post goes well into the tax code and court cases, and while that is awesome, you might want something more condensed if you're just perusing the web for an explanation. My goal is here is to summarize some of Tony Nitti’s article, and the underlying tax code, for those who want the quick and dirty version. Link to Tax Guru Tony Nitti's Article on Real Estate Professionals and I highly recommend it if you’re wanting a deep dive.
Qualifying as a real estate professional potentially allows a taxpayer to deduct rental losses in full, whereas they otherwise may not be allowed in a current year. This qualification, if applicable, also then avoids the 3.8% Section 1411 net investment income tax on qualifying rental property income.
To take advantage of this preferential treatment, a taxpayer must first qualify as a real estate professional – perform substantial services in a real property trade or business – and then must prove material participation in each rental activity, or group them if appropriate to meet total material participation hours. Material participation tries to prove the taxpayer is substantially active in an activity, rather than passively investing or minimally engaging. A taxpayer can try to establish material participation by satisfying any one of seven tests provided in IRS Publication 925. If you get in there and get lost, do a CTRL + F and search for “material participation” - it's long.
Here’s why this is all potentially so beneficial. Rental activities in general are considered a passive activity and this comes from Internal Revenue Code Section 469, enacted in 1986 tax reform to in part curtail using casual rental properties as a tax shelter, and states only passive income can offset passive losses. Any excess passive losses in a year are not allowed in the current year and are carried forward to future years until either passive income is generated to offset prior unused passive losses, or the activity is disposed. As such, rental losses are only deductible up to the amount of passive income reported – which in many cases for the average taxpayer is zero.
While Section 469 defines any rental activity, regardless of taxpayer’s level of participation to be passive, Section 469(c)(7) was later added to avoid unfair treatment to those actually participating in the active business of renting real estate, when associated with another similar non-rental activity such as selling or developing real estate. The provision gives the 'qualifying real estate professional' exception to treating rental activities as passive, thus allowing a potential deduction for rental losses in the current year.
To first qualify as a real estate professional, the taxpayer must prove substantial involvement in a real property trade or business by satisfying two tests provided under Section 469(c)(7)(B):
· more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
· the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
Court cases argue that aggregation of rental activities with other real property trades or businesses can be done in satisfying the first hurdle of materially participating in the real property business. Here’s a classic example below, provided by Tony’s article:
"Ex: A is a real estate broker who also owns three rental properties. For other purposes of Sec. 469, A would be considered engaged in four separate activities. For the purposes of qualifying as a real estate professional, however, if the facts and circumstances warrant, A may treat her brokerage activity and three rental properties as one real property trade or business. This would allow A to measure the combined hours spent on the brokerage business and the three rental properties to establish that she materially participates in the combined real property trade or business."
Next, the taxpayer needs to prove material participation in each of their rental activities. Note that for taxpayers with multiple rental properties, the statute requires material participation in a rental activity must be established separately for each activity. However, you can elect to aggregate rental property activities for measuring material participation for the test under Section 469(c)(7)(A). Careful here though, the election cannot be revoked unless a material change in facts and circumstances arises.
If aggregated and combined activity is materially participating, then all those rental activities are considered nonpassive (you made it!). However, if they do not add up to material participation, the activities remain passive (sorry, still limited).
See below for Tony Nitti’s 5 Steps to Qualify as a Real Estate Professional and treating rentals as nonpassive activities:
Step 1: Identify and group the taxpayer's real property trades or businesses.
Step 2: Identify the taxpayer's real property trades or businesses in which the taxpayer material participates.
Step 3: Total the hours of participation in those real property trades or businesses in which the taxpayer materially participates. If the taxpayer is married, only count the hours from the spouse seeking to qualify as a real estate professional.
Step 4: Apply the hours from Step 3 to the two quantitative tests of Sec. 469(c)(7)(B):
Do the hours represent more than one-half of the total personal service hours the taxpayer performed during the year in all trades or businesses? Do the hours exceed 750?
Step 5: A taxpayer who passes both tests in Step 4 is a qualifying real estate professional. The qualifying real estate professional must next establish material participation in his or her rental activities.
Sorry my mortgage broker friends, I know a lot of you guys too! But your mortgage broker services don’t count as a real property trade or business for the purpose of qualifying as a real estate professional.
Also, if your spouse is participating in any of the real estate activities, things get more complicated! Publication 925 states, “If you file a joint return, don’t count your spouse's personal services to determine whether you met the preceding [qualifying real estate professional] requirements. However, you can count your spouse's participation in an activity in determining if you materially participated”. The spousal piece can get tricky, read Tony’s article for a more in depth look.
And, if you don’t qualify as a real estate professional, there’s a chance you can still deduct some rental losses. If your income is under $100,000 ($50,000 married filing separate), you could potentially deduct up to $25,000 ($12,500 MFS) of rental losses in an activity in which you actively participate. Active participation is much easier to attain than material participation; yes, they are different!
If it still sounds confusing, that’s because it is! Reach out to your tax advisor for a full review of your unique tax picture to see if you qualify for any of these real estate tax breaks.