Real Estate Professionals: Qualifying for Passive and Investment Tax Benefits
Real estate investment is a popular vehicle for wealth building, but unless a taxpayer qualifies as a “real estate professional,” there are additional tax liabilities to consider. As such, it’s worth it for people working in real estate to determine whether they qualify under the IRS’s definition. Doing so allows real estate workers to avoid passive income loss limitations and the net income investment tax.
Passive Activity Loss Limitations and How They Affect Real Estate Investors
The IRS has a different set of tax rules in place for what it defines as “passive activity.” Losses from passive activities cannot be used to offset gains past the amount of income earned by the activity. Instead, they must be carried into future years and used to offset future income, or until the passive activity is ceased.
Rental real estate activities are considered passive by the IRS, so they are subjected to the above rules. With those limits in place, real estate rental investors cannot deduct losses beyond their income in the year they are incurred. And those losses cannot be used to offset gains made in other forms of nonpassive income – such as wages.
The Net Income Investment Tax and How it Affects Real Estate Investors
The net income investment tax (NIIT) is a 3.8 percent charge on certain types of passive-generated income. Real estate rental income is considered passive for the purposes of the NIIT, so investors are saddled with an additional tax burden through the NIIT.
The NIIT is applied to the lesser of:
- The taxpayer’s net investment income
- The extent to which the taxpayer’s modified adjusted gross income (MAGI) extends past their income threshold (based on the taxpayer’s status)
By qualifying for real estate professional status, taxpayers can avoid paying the NIIT on their rental activities.
How Qualifying for Real Estate Professional Status Can Help Reduce Taxes
The IRS does provide real estate professionals with tax advantages if they qualify under the agency’s definition. The definition is complex and involves a couple of primary criteria, including:
- More than half of all personal services the taxpayer provided during the tax year were performed in real property trades or businesses the taxpayer materially participated in.
- The taxpayer provided at least 750 hours of services during the tax year. These services must be real property trades or businesses that the taxpayer materially participated in.
These criteria do not apply to employees of real estate companies, unless the employee had at least a 5 percent ownership stake in the business.
“Material participation” are the operating words in the IRS’s definition. As such, calculating a taxpayer’s material participation in a real estate trade is a major part of assessing real estate professional qualifications.
Determining Material Participation for Real Estate Professionals
Real property trades and businesses include the following:
Material participation in any of the above is counted toward real estate professional qualification. But what does material participation mean? It means “regular, continuous and substantial” involvement in the activity. Specifically, material participation means fulfilling the following criteria:
- The taxpayer participated in the activity for at least 500 hours during the relevant tax year.
- The taxpayer’s participation substantially constituted all of the work in the activity.
- The taxpayer worked at least 100 hours in the activity during the tax year, and no one else worked more than the taxpayer in the activity – including employees.
- The activity is considered a significant participation activity (SPA) for the tax year. The taxpayer must accrue at least 500 hours of work across all SPAs. Rental and leasing work is not considered an SPA.
- The taxpayer materially participated in the activity for five of the previous 10 tax years. These do not need to be consecutive.
- The activity is a personal services activity and the taxpayer materially participated in the activity during the previous three tax years.
- Based on all facts, circumstances and information, the taxpayer participated in the activity on a continuous, regular, and substantial basis throughout the year. The taxpayer must spend at least 100 hours engaged in the activity, and acting in a management or supervisory role does not count if someone else was compensated for managing the activity, or if someone else managed the activity longer than the taxpayer.
To meet the real estate professional requirements, taxpayers may elect to treat all of their real estate rental activities as a single activity. If this election is not made to the IRS, the agency will treat each rental activity as separate. This may disqualify a taxpayer that would otherwise qualify to be considered a real estate professional.
To ensure a real estate professional can leverage their tax benefits, they must file a statement with their original income tax return declaring that they are a qualified taxpayer for the year and that they intend to group all rental real estate interests as a single activity. Once this election is made, it remains in place for future years and cannot be reversed unless there is a material change in circumstances.
There’s Still a Rental Real Estate Loss Allowance for “Active” Participants
Taxpayers may deduct up to $25,000 in rental real estate losses even if they do not qualify as real estate professionals, as long as they are considered “active” participants in the activity. To be considered an active participant, the taxpayer must have owned at least 10 percent of the property and made management decisions regarding the property – or arranged for someone to make those decisions in a significant, bona fide sense.
Approving new tenants, negotiating rental terms, and approving expenditures are all examples of management decisions.
Work with an Experienced Tax Accountant To Learn if You Qualify for Real Estate Tax Benefits?
Rental real estate is a complicated area as far as taxes are concerned. It’s important for rental real estate investors and workers to determine if they qualify to be considered real estate professionals for tax purposes.
An experienced tax accountant with real estate experience can help their clients determine this eligibility, which may be confirmed through appointment and accounting books, calendars, and other work summaries. The IRS is particular about what documentation can be used to support a taxpayer’s participation in real estate activities.
Again, an experienced tax accountant can help sift through a client’s work history documentation and ascertain whether or not they would qualify for additional tax benefits. There is extensive court history involving the IRS and rental real estate investors – typically arguing whether or not the investor qualifies as a real estate professional. Many of these cases have ended with the taxpayer responsible for additional tax liabilities.
By working with a seasoned tax accountant with real estate experience, rental real estate investors can optimally leverage their tax benefits by eliminating loss limits and avoiding investment tax liabilities.
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