Over the years, many of our clients have asked about deducting rental activity losses. Our response typically starts something like this: “Well, it depends…”
In general, the IRS recognizes rental real estate activities as passive activities, even if you’ve materially participated in them. And, in most cases, losses from passive activities can only be deducted if they are offset by passive income. But if you qualify as a real estate professional, the IRS sees your rental activities as nonpassive—that is, eligible for deductions.
At this point, you may be thinking, “Sign me up!” Before you check the “real estate professional” box on your tax return, here are a few things you should know.
A real estate license does not make you a real estate professional.
Let’s first clear up this common misconception: Holding a real estate license or working in the real estate industry—even for decades—does not make you a real estate professional…in the eyes of the IRS. When we refer to qualifying as a real estate professional, we mean for tax purposes.
According to the IRS, you must meet these two requirements to file as a real estate professional:
- 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.
The IRS defines real property trades or businesses as those that do any of the following with real property:
- Develops or redevelops it.
- Constructs or reconstructs it.
- Acquires it.
- Converts it.
- Rents or leases it.
- Operates or manages it.
- Brokers it.
Personal services you performed as an employee in real property trades or businesses, however, do not count, unless you were a 5 percent owner of your employer. And if you file a joint return, you are unable to count your spouse’s personal services. But you can count your spouse’s participation in an activity in determining if you materially participated.
Documentation is very important.
It’s not unheard of for the IRS to investigate how you qualified as a real estate professional. This is especially true if your numbers seem aggressive. For this reason, be sure to accurately document the number of hours you worked on rental activities during the day or week. If you’re asked to prove how you met the 750-hour requirement, you’ll be prepared.
Qualifying as a real estate professional isn’t always beneficial.
Meeting the IRS’s real estate requirements requires effort, and it won’t always pay off. For instance, if you have several rental activities that don’t incur losses, qualifying as a real estate professional may not make sense for you. This is not true, however, if you file a joint return and have income in excess of $250,000; qualifying as a real estate professional may help you avoid the 3.8% net investment income tax. Bottom line: Before you go to the trouble to qualify, talk with your tax advisor to make sure real estate professional status is right for you.