In early June, the U.S. Tax Court issued a Summary Opinion that benefits real estate professionals who also work in other industries. Now individuals who hold part-time jobs in fields other than real estate may be able to deduct tax losses generated from owning real estate.
Before we get into the specifics of the court case, it is important to understand some background on the elections and classifications available to those who qualify as real estate professionals.
The IRS identifies which real estate activities classify as passive for tax purposes. It also defines what constitutes as material participation, which is a requirement when taxpayers want to take advantage of their passive activity losses. When an activity is classified as passive, it limits the taxpayer’s ability to deduct any losses against ordinary income. The most common activity that is classified as passive is rental real estate.
Select individuals may qualify to be classified as real estate professionals. The benefit of being classified as a real estate professional is that you are allowed to offset ordinary income with the losses generated from real estate activities. Without this classification, the losses must be suspended until you have passive income to offset those losses against. There are two tests that must be met to qualify for this classification. First, more than 50% of personal services provided must be for real property businesses they materially participate in; and second, they must have more than 750 hours of service related to real property trades or businesses during the tax year.
Court Case Overview
In the Summary Opinion filed on May 23, 2016, the rental real estate losses of a couple were disallowed because the husband was a full-time pilot and the wife was a part-time ski instructor. The taxpayers owned three rental properties and the wife spent 200 or less hours a year in her part-time ski instructor role and well over 750 hours providing services to the rental properties. However, the IRS disallowed their deduction for the losses incurred, reclassifying the losses as passive rather than active. When the taxpayers were able to produce logs to show how much time they spent and what activities they were doing during each of the years in question, the U.S. Tax Court ruled in their favor. The taxpayers were allowed to deduct the losses against ordinary income due to their classification as a real estate professional.
Additional Ways to Utilize Rental Property Losses
Additionally, the IRS established ways in which taxpayers can take advantage of passive losses regardless of their inability to be classified as a real estate professional or their lack of passive income. One of these is through the $25,000 allowance for rental real estate if their adjusted gross income (AGI) does not exceed $150,000 (there is a dollar-for-dollar phase-out that begins when AGI. falls between $100,001 and $150,000).
Another way for the taxpayer to take advantage of such losses when they have multiple rental properties is to do a grouping election to treat all activities as a single activity (i.e., rental real estate, construction, etc.) so they can meet the requirements needed for material participation.
For example, if you own 10 rental properties under the regulations you are required to spend 7,500 hours (750 x 10) in total dedicated to rental real estate for the year. By making the grouping election to treat all 10 rental properties as one, your hour requirement for the year is only 750.
It is important for taxpayers who own one or more rental properties to keep adequate records to show how time is being spent as well as what activities they are doing on their rental properties. By having adequate documentation of time spent (logs), receipts or detailed invoices for purchases, your CPA will be able to better determine what rental losses are deductible as well as whether a grouping election can be made to allow for additional losses to offset other income. By having extensive documentation, you can reduce the risks under audit of items being disallowed or activities being reclassified to passive.