It is not easy to qualify as a real estate professional. However, if you do qualify as a real estate professional you are entitled to an income tax treatment that may benefit you.
Tax Benefits to Real Estate Professionals with Rental Losses
Typically, all rental activities are treated as passive activities, regardless of the individual owner’s extent of involvement. Taxpayers generally may use losses from passive activities only to offset income and gains from other passive activities. If the taxpayer doesn’t have sufficient passive income to offset the passive losses, the excess losses cannot be used currently, and instead are carried forward to future years.
An exception to this rule is made for the “Real Estate Professional.” The idea is that someone who earns their living in real estate businesses should be allowed to use real estate rental losses without limitation. Real est
ate professionals may treat otherwise passive rental real estate activities as nonpassive if the taxpayer materially participates in the rental activity. Losses from such activities can be used to offset any other income, such as wages and interest. This preferential treatment is only available to eligible individual taxpayers who are considered to materially participate in the rental activity, qualifying under some very specific rules.
Who qualifies as a “Real Estate Professional?”
Step 1 – Participate in a Real Property Trade or Business
To be eligible for the real estate professional special rules, the taxpayer must participate in real property trades or businesses rather than participate in business activities that have real estate transactions.
A real property trade or business is broadly defined to include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage (a real estate broker, not a mortgage broker)
Step 2 – Meet Both of the Following Requirements:
- More than 50% of personal services performed by the taxpayer in all trade or businesses during the tax year are performed in real property businesses in which the taxpayer materially participates, and
- The taxpayer performed more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.
Generally, if the real estate professional participates in multiple activities, the rules require that the taxpayer materially participates in each rental activity, satisfying the 50% and 750-hour requirements. That could present a difficult or even impossible burden, but there is relief (see grouping election later).
Material Participation Defined
The material participation rules list seven ways to establish material participation. Only one of the seven tests need be met. Seven Tests of Material Participation:
- The taxpayer participates in the activity for more than 500 hours during the tax year.
- The taxpayer’s participation was substantially all the participation in the activity by all individuals.
- The taxpayer participates in the activity more than 100 hours during the tax year, and the taxpayer’s participation is not less than the participation of any other individual.
- The activity is a “significant participation activity” and aggregate participation in all significant participation activities exceeds 500 hours. An individual is treated as significantly participating in an activity for a taxable year if the individual participates in the activity for more than 100 hours during the tax year.
- The taxpayer materially participated in the activity for any five of the 10 immediately preceding tax years.
- The activity is a personal service activity and the taxpayer materially participated for any three years preceding the tax year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during the tax year. To meet this test the taxpayer must have participated at least 100 hours.
In order to substantiate material participation in case of an income tax audit, taxpayers should keep a log of time spent performing these activities.
The taxpayer may elect to treat all interests in rental real estate activities as one activity. If the taxpayer does not formally make the election, each rental activity will be treated as a separate activity,with each separate activity being subject to the possible carryover to future year(s) of the current year losses if the material participation test is not met. By making the election the taxpayer only needs to satisfy the material participation rules for the group of activities rather than for each separate activity. The grouping election is made by attaching a statement to the taxpayer’s income tax return. However, making the election will not always yield favorable results. Each taxpayer’s situation should be considered carefully before the election is made.
One Other Possible Benefit for the Real Estate Professional
Taxpayers with taxable income above $200,000 (or $250,000 for taxpayers filing married-filing-jointly) are subject to the net investment income tax, which is an additional 3.8% surtax assessed on the taxpayer’s passive income. Again, rental income is generally considered passive and would be subject to this surtax. However, if a taxpayer qualifies and elects to be treated as a real estate professional, the net rental income will not be considered passive and will not be subject to the 3.8% net investment income tax.
This article is just a brief summary of the Real Estate Professional qualification rules and related tax benefits in an effort to provide you with an introduction to the subject. It does not discuss all tax situations, define all terms, or list the many exceptions and limitations to the rules. Please consult your WNDE tax advisor if you think the real estate professional rules may apply to you in your particular tax situation.