Are You a Tax-Favored Real Estate Professional?

For federal income tax purposes, the general rule is that rental real estate losses are passive activity losses (PALs). An individual taxpayer can generally deduct PALs only to the extent of passive income from other sources, if any. For example, if you have positive taxable income from other rental properties, that generally counts as passive income. You can use PALs to offset passive income from other sources, which amounts to being able to currently deduct them.

Unfortunately, many rental property owners have little or no passive income in most years. Excess rental real estate PALs for the year (PALs that you cannot currently deduct because you don’t have enough passive income) are suspended and carried forward to future years. You can deduct suspended PALs when you finally have enough passive income or when you sell the properties that generated the PALs.

Exception for professionals
Thankfully, there’s a big exception to the general rule that you must have positive passive income to currently deduct rental losses. If you qualify for the exception, a rental real estate loss can be classified as a non-passive loss that can usually be deducted currently.

This exception allows qualifying individual taxpayers to currently deduct rental losses even if they have no passive income.

To be eligible for the real estate professional exception:

• You must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
  
  
• Those hours must be more than half the time you spend delivering personal services (in other words, working) during the year.

If you can clear these hurdles, you qualify as a real estate professional. The next step is determining if you have one or more rental properties in which you materially participate. If you do, losses from those properties are treated as non-passive losses that you can generally deduct in the current year.

Here’s how to pass the three easiest material participation tests for a rental real estate activity:

1. Spend more than 500 hours on the activity during the year.
   
   
2. Spend more than 100 hours on the activity during the year and make sure no other individual spends more time than you.
   
   
3. Make sure the time you spend on the activity during the year constitutes substantially all the time spent by all individuals.

If you don’t qualify
Obviously, not everyone can pass the tests to be a real estate professional. Thankfully, some other exceptions may potentially allow you to treat rental real estate losses as currently deductible non-passive losses.

These include the:

• Small landlord exception. If you qualify for this exception, you can treat up to $25,000 of rental real estate loses as non-passive. You must own at least 10% of the property generating the loss and actively participate with respect to that property. Properties owned via limited partnerships don’t qualify for this exception. To pass the active participation test, you don’t need to do anything more than exercise management control over the property in question. This could include approving tenants and leases or authorizing maintenance and repairs. Be aware that this exception is phased out between adjusted gross incomes (AGIs) of $100,000 and $150,000.
  
  
• Seven-day average rental period exception. When the average rental period for a property is seven days or less, the activity is treated as a business activity. If you can pass one of the material participation tests, losses from the activity are non-passive.

30-day average rental period exception.
The activity is treated as a business activity when the average rental period for a property is 30 days or less and significant personal services are provided to customers by or on behalf of you as the property owner. If you can pass one of the material participation tests, losses from the activity are non-passive.

Utilize all tax breaks
As you can see, various taxpayer-friendly rules apply to owners of rental real estate, including the exceptions to the PAL rules covered here. We can help you take advantage of all available rental real estate tax breaks.