The use of rental losses to offset other types of taxable income has been severely limited since the passive activity rules were added to the Internal Revenue Code in 1986. These rules mandate that taxpayers cannot offset income, other than passive income, with losses from passive activities. Generally, under those rules, rental losses are deemed passive by definition and NOT able to reduce taxable income from other sources, except if the taxpayer or their spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from non-passive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you may be able to offset credits from the activity against the tax on up to $25,000 of non-passive income after taking into account any losses allowed under this exception.
There is a second more important provision within the Internal Revenue Code that was added in 1993 to assist those who real estate business activities qualify them as “real estate professionals”. If a taxpayer qualifies as a real estate professional, rental real estate activities in which you materially participated are not passive activities.
The three important aspects of this provision are the definition of a real property trade or business, the definition of a real estate professional and whether or not the taxpayer materially participates in the operation and management of that business.
The Internal Revenue Service instructions title Reporting Rental Income, Expenses and Losses defines a real property trade or business is a trade or business that does 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.
To qualify as a real estate professional, the instructions note that the taxpayer must meet both of the following requirements.
- More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
- You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.
If you qualify as a real estate professional, rental real estate activities in which you materially participated are not passive activities.
Material participation is the key issue in most cases revolving around these tax situations. Generally, a taxpayer is found to have materially participated in an activity for the tax year if he or she were involved in its operations on a regular, continuous, and substantial basis during the year.
A recent Federal Court case (Charles and Delores Gragg, 118 AFTR 2d 2016-XXXX (CA 9)) ruling against the taxpayer illustrates the affects of failing to comply with the rules regarding rental property losses.
In this case, the taxpayer was a licensed real estate agent who owned several rental properties. For tax years 2006 and 2007, she deducted a total of $78,543 in rental losses. Upon examination, the Internal Revenue Service disallowed these losses because the taxpayer failed to show she materially participated in the rental activity.
The taxpayer argued that her status as a real estate professional automatically rendered the losses non-passive, “regardless” of material participation. The United States Court of Appeals for the Ninth Circuit sided with the Internal Revenue Service, holding that although real estate professionals are not subject to the per se rule under the Internal Revenue Code that rental losses are [automatically] passive, they must still show material participation before deducting rental losses. Therefore, the taxpayer was not entitled to deduct the losses.
It is hard to imagine taking cases such as this one to the Court of Appeals when the taxpayer failed to comply with direct statutory law. The facts of this case left the Court no room to decide otherwise.
As one can observe, the tax ramifications of acquiring real property for rental purposes can be fraught with complexity. Should you have questions regarding this case, the use of rental losses on your returns, or any other aspect of holding real property for the production of income, please contact Bob Grossman or Don Johnston.
