Which are you? The answer may surprise you!
There are many taxpayers over the past several years that have been able to capitalize on the rollercoaster real estate market and invest in properties for lower than market value. For many rental real estate owners, this has been a very profitable enterprise. However, many rental properties create losses on your income tax return that are not allowed to be used to offset other income. These losses, known as passive activity losses (PAL), can accumulate over the years because they are not being used. Let’s consider what it takes to be considered a “real estate professional” for income tax purposes.
A very important issue to note from the start is that you don’t have to work full-time in the real estate industry to be considered a real estate professional. There are three keys to qualifying as a real estate professional.
The first key is material participation. The tax law considers material participation as being involved in operating the activity in a substantial way on a regular basis. If an individual meets one of the seven tests, as outlined by the in the law, they will be considered as having material participation for that specific activity.
Here are the tests most often used to determine material participation:
- More than 500 hours of participating in the activity during the tax year.
- Participating more than 100 hours in the activity during a tax year, only if no one else participated more.
- Materially participating in the activity for any five of the last 10 tax years before the current year.
Material participation generally has to be established annually and does not carry forward year after year. If the taxpayer owns more than one property, a federal tax election should be made to consider all properties owned as one activity. If the taxpayer owns more than one property, a federal tax election should be made to consider all properties owned as one activity. Otherwise, the material participation test would need to be met for each individual property and that can be much more difficult to accomplish.
The second key to this qualification is that the amount of time spent materially participating in real estate businesses for the tax year must be more than 50% of the total time spent in performing personal services in all businesses for which you have a role. This does not pertain to work performed as an employee of a company.
The third key to consider is that the number of hours spent performing these services in real estate businesses for which you materially participate, must total more than 750 hours during the tax year.
The tax benefit of qualifying under this test is to have the rental activities considered non-passive so that any losses generated can be used to offset non-passive income (typically salaries, interest, dividends, or income from other non-real estate businesses). There is much more information to consider when it comes to this topic than we have space to cover in one article.
The best way to determine whether this is something that would apply to you would be to have a conversation with Mark Fly at Price CPAs. His knowledge and insights in this area may help determine some benefits to apply for you this tax season. You can reach Mark at Price CPAs, 615/385-0686 or Mark@PriceCPAs.com.