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The Real Estate Professional Election and the IRS
Passive losses cannot be deducted except against passive gains. Acquiring eligibility as a real estate professional can have significant tax advantages. Real estate professionals can deduct expenses from nonpassive sources. The $25,000 limit on active participation in rental real estate does not apply to the real estate professional; all loses are deductible against passive and nonpassive income.
I will outline in this article who a real estate professional is, how to get the IRS to acknowledge your status as a real estate professional, and the tax savings involved. The IRS defaults passive activities to passive activity rules where loses are suspended into future years when passive profits are realized. Since the expenses must be paid now, many taxpayers desire a tax break now, as the costs are incurred. Designation as a real estate professional allows a full tax deduction of all real estate loses when handled properly.
Who is a Real Estate Professional?
There are two qualifications in addition to material participation an individual must meet:
- Over 50% of services during the tax year must be performed in a real estate trade you materially participate in, AND
- You spend over 750 hours servicing real estate businesses you materially participate in.
Example #1: John works 1,000 hours per year; 500 at his paper mill job and 500 managing several of his rental properties. John is not a real estate professional because he did not work over 750 hours at a real estate trade or business.
Example #2: John works 2,000 hours a year at his paper mill job and 800 hours running his rental properties. John is not a real estate professional because he did not spend over 50% of his time at a real estate trade or business.
Example #3: John works 1,000 hours a year at his paper mill job and 1,250 hours managing his rental properties. John is a real estate professional because he spent over 50% of his time and over 750 hours in a real estate trade or business.
- Passive Activity Rules
Passive activity rules can work to your advantage if you know how. Passive activity losses are limited with notable exceptions.
What is Material Participation?
Material participation is required to be a real estate professional. You can elect to lump all your real estate activities into one activity to meet the material participation rules. You inform the IRS you are a real estate professional by attaching a statement to your original tax return saying you are a qualified taxpayer for the tax year and are filing the election pursuant to Section 469(c)(7)(A).
The election is irrevocable. Only a material change in the facts and circumstances can end the election. You can read more about material participation here.
What is a Real Estate Trade or Business?
A real estate trade or business includes:
- Rental properties
- Leasing and brokerage
This list is not inclusive. Additional services provided in the real estate industry also apply.
Note: Services as an employee do not count unless the employee is a 5% or more owner.
Married couples can combine activities to determine if they materially participate. At least one spouse must satisfy the requirements above: >50% of services AND >750 hours.
It is important to substantiate your hours of service. A recent court ruling (Mowafi TC Memo 2001-111) made clear the requirement to record hours of service at the time service is provided. A daily log of ALL services, real estate and non-real estate, is required to satisfy IRS real estate professional rules.
Additional Tax Issues
Self-employment tax is never paid on rental real estate income. The exceptions include real estate dealers, hotels/motels, and boarding houses. Hotels/motels and boarding houses are subject to self-employment tax if they provide significant services. Lawn care and snow removal is not considered significant; daily cleaning and turning the beds is.
Care should be taken when considering the election to be treated as a real estate professional. Other passive activities are handled separately on the tax return and cannot be used to reduce real estate professional income. Since the election is irrevocable, consideration to future tax years is a must.