We get a lot of calls from people who want to start dabbling in real estate. While real estate can be a lucrative investment over time, those who want to dabble in real estate should be aware of how their investments will impact their taxes.
If you are considering getting into real estate investing, there are a few key things you should know in order to increase your odds of making it a lucrative venture.
The question new real estate investors most often ask is how they can shelter other income, primarily income from their W-2, using the losses generated from their real estate investment. People often get into real estate investing because they believe those losses are generated from depreciation, and they expect a positive cash flow while also getting a tax deduction.
Sounds like a pretty sweet deal, right? Well, it can be. But, you will have to clear a couple of hurdles to be able to take those losses on your tax returns.
Let’s look at those hurdles and what you need to do to overcome them. But before we get into the two tests you must pass in order to take the losses, we have to define “passive activity” and “active participation.”
Passive Activity: What Is It?
Passive activity is any activity where the investor does not “materially participate” (as defined below) in the activity of the investment. By default, unless there are certain fact patterns, real estate is considered a passive activity.
Passive activity losses can only be used to offset passive activity income. So unless you have other real estate or passive investments that are generating a taxable income, the losses created by the real estate entity will not shelter other taxable income. Rather, they will be carried forward until you generate some passive income or sell the investment.
Active Participation: What Is It?
Active participation is an exception that only applies to real estate investments. If you actively participate by making management decisions, such as approving new tenants, approving expenditures as well as having at least a 10% interest in the investment, then you may be able to take some of the passive losses if certain conditions are met.
If your modified adjusted gross income (MAGI) is $100,000 or less, then you can deduct up to $25,000 of passive losses. For every $2 above $100,000 you lose $1 of the deduction. Once your MAGI hits $150,000 you will not be able to take any passive losses (assuming you do not have any passive income).
Material Participation Test
Before I give the IRS’s definition of material participation, I want to point out that even after a real estate investor clears this hurdle there is another hurdle, called a “real estate professional,” that needs to be overcome before any losses can be taken. It’s worth noting that in all other industries, you can take losses once you pass the material participation level, as they are no longer considered passive.
To pass the material participation test, you must meet at least one of the following requirements:
- The individual worked in the activity for 500 or more hours during the year,
- The individual's participation in the activity constitutes substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own an interest in the activity,
- The individual participated in the activity for more than 100 hours during the tax year, and the individual's participation was at least as much as any other individual for the year,
- The activity is a "significant participation activity” for the year (more than 100 hours participation per activity with an aggregate of 500 hours),
- The individual materially participated in the activity for any five of the ten immediately preceding tax years, whether or not these were consecutive,
- The activity is a personal service activity and the individual materially participated in the activity for any three preceding tax years, or
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Real Estate Professional Test
To be considered a real estate professional you must meet BOTH requirements.
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Two Real-Life Examples of the “Real Estate Professional” Test
Let’s look at two real-life situations and whether those real estate investors would pass the real estate professional test. Remember, both requirements described above must be met in order to be considered a real estate professional.
A surgeon who owns several rental properties and handles all aspects of the properties works over 750 hours in real property, but also works 2,000 hours in their medical practice during the tax year. They would pass #2 but not #1. Because less than 50% of the personal services they performed were related to real property trades or businesses, they would not be considered a real estate professional.
A contractor who owns several rental properties and works 100 hours on the real property would qualify as a real estate professional. That’s because the construction work they do is considered part of a “real property trade or business,” which counts towards the 50% test even though rental real estate is not their primary line of work.
Real estate investing is most likely to be profitable when you take tax rules into account before diving in. But there’s a lot of gray area, as every investor’s situation is slightly different.
Contact our tax department here or call 800.899.4623 to learn how to maximize losses related to real estate investments.