Rental real estate owners are often faced with the dilemma of whether to keep their rental properties or to dispose of them due to the expenses incurred in maintaining and managing them. Since the losses qualify as passive activity losses, they can be claimed only against a passive activity income. Recently at AG Tax we had a client facing a similar situation, where the client inquired whether they would be able to claim their rental property expenses as deductions against other sources of income, or whether they should get rid of the non-profitable properties. We provided them with a detailed analysis of both scenarios, and thought it would be beneficial to prepare a brief summary on how one can claim their rental income as active income by showing a rental business/trade. This information should be highly informative for other real estate owners contemplating the same.
Rental Income, Passive Activity & Passive Activity Loss
Income derived from a rental property, or other means in which the taxpayer is not actively involved is considered to be ‘passive income’. However, irrespective of the amount of time put in by the property owner in maintaining, renovating, advertising it, or looking for suitable tenants, this activity is still considered as ‘passive activity’. Thus, any loss incurred on the real estate property is considered to be a ‘passive activity loss’ (PAL). This loss can only be deducted against passive activity income, and not against active income (wages, salary, etc.). Similarly, passive activity tax credits also generally only qualify to reduce taxes payable on passive income.
Qualifying Rental Income as Active Income
As per the IRS, rental income in certain cases may qualify as active income if there is either active participation, or material participation by individuals running a rental real estate trade or business. Active Participation: Active participation is not the same as material participation, which is defined later. Active participation is easier to meet than material participation. For example, an individual may be treated as actively participating if they make significant and bona fide management decisions. Per the IRS, management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions. Taxpayers may deduct up to $25,000 of losses ($12,500 if married filing separately) and credits from passive rental real estate activities against active income, such as salary, wages, etc., if they “actively participating” in those activities. An individual must own at least 10% of the rental property to qualify, and the $25,000 ‘active participation’ exemption phases out if the taxpayer’s adjusted gross income (AGI) is more than $100,000. It phases out completely when AGI is $150,000. Material Participation Any trade or business is generally a passive activity unless material participation is achieved by meeting any one of seven tests:
- The taxpayer works 500 hours or more during the year in the activity.
- The taxpayer does substantial work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
Despite meeting the material participation rules, any real estate loss remains passive (the $25,000 limit remains in effect) unless the individual qualifies as a real estate professional.
Qualifying as a Real Estate Professional
In order to qualify as a real-estate professional, the taxpayer must materially participate in a real estate business (i.e. renting and/or leasing of owned real-estate), dedicating more than 50% of their personal services during the tax year towards the real estate business, which should amount to more than 750 hours, excluding any work performed as an investor. They must also own at least 5% of the real estate business. This does not disqualify one from owning another business or working as an employee along with pursuing their real-estate business provided the material participation conditions are fulfilled. It is important to note that the IRS treats each rental real estate property owned as separate activity/ business, unless an election has been made to treat all interests as a single activity. Therefore, an election to treat all properties as a single activity is an absolute necessity. Otherwise the property owner/taxpayer would need to establish material participation for each property separately (i.e. 750 hours of material participation in each property) to qualify as a real-estate professional. This could be very difficult for someone carrying out another business, and/or holding multiple rental properties. That being said, these tests are applied on an annual basis, and due to this an individual may not qualify as a real estate professional every year. Thus a real estate activity loss may either qualify as ‘passive activity loss’ or ‘non-passive activity loss’ depending upon the real-estate professional’s eligibility for that particular tax year.
AG Tax LLP Can Help
If you wish to discuss further on the above issue, have any tax-related queries, or need assistance with tax planning or filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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