Do you own rental property? Have you ever wondered if owning rental property makes you a real estate professional? Being considered a real estate professional by the taxing authorities offers serious perks and tax breaks. In general, losses generated by rental real estate are considered passive and can be offset only by other passive income sources. This limits your options for income tax reduction. Real estate professionals, however, can bypass this limitation and offset losses with any other form of ordinary income.
The Benefits of Rental Real Estate
Owning rental real estate can be quite advantageous to taxpayers. Most importantly, taxpayers can generate positive monthly cash flow. In addition, deductions such as mortgage interest and property taxes can reduce income without the usual limitations associated with Schedule A deductions. Taxpayers can also defer gains through property exchanges and take depreciation on their investments. This can be used to effectively turn actual income into tax losses.
Who Qualifies as a Real Estate Professional?
Successfully taking advantage of the benefits of rental real estate requires navigating complex tax rules. Taxpayers must understand the differences between passive income and ordinary income and issues unique to real estate professionals. Real estate professionals are given the ability to offset real estate losses with ordinary income (such as wages, interest and dividends, self-employment income, or retirement income). To take advantage of this, however, taxpayers must prove that they are actually deriving their livelihood from real estate. In general, there are three main criteria through which qualifying status is determined:
- The taxpayer must own at least one interest in rental real estate.
- More than one-half of the services performed by the taxpayer during the year must involve real property where the taxpayer or taxpayer’s spouse is materially involved.
- The taxpayer must perform more than 750 hours of service during the year in real property trades or businesses in which the taxpayer materially participates
It is important to note that each interest in rental real estate is considered separately when applying the above criteria, unless an election is made to combine real estate interests.
If a taxpayer does not qualify as a real estate professional, which is more often than not, a special passive activity loss limitation exception offers a rental real estate loss allowance. Taxpayers with adjusted gross incomes of $150,000 or less can claim a rental real estate loss of up to $25,000 for property they actively manage. Active management does not require the material participation necessary to be considered a real estate professional. However, it does require taxpayers to own at least 10% of the property in question and married taxpayers to file a joint return.
Be Prepared in the Event of an Audit
Because of the tax benefits derived from real estate professional status, IRS agents carefully scrutinize taxpayer claims for the exemption. Some of the key disqualifiers agents look out for include:
- Forms W-2 which are from non-real estate sources
- Spouses who both claim to devote time to real estate
- Material participation in multiple real estate activities
- All claims that the taxpayer is in a real property trade or business
The general idea behind investigating these items is to ensure that the taxpayer, as an individual (even when filing with joint status), meets the qualifications of real estate professional status. Proper records in these four areas go a long way to countering any audits that can result from claiming this exemption.
Anyone who owns rental property should consider looking into the real estate professional requirements. These are federal rules only, California does not conform to the real estate professional rules. There are serious tax benefits that can result from qualifying for this status and/ or planning in accordance with the $25,000 rental real estate loss allowance. The topic is complex, however, and we recommend further discussion with your tax professional. If you have any question regarding how these rules apply to your particular situation, please contact your L&B professional for more information.