Tax Law Test for Real Estate

12-28-2022Tax Information

The IRS often scrutinizes large deductions for rental real estate losses claimed by so-called “real estate professionals.” In a new case involving a couple that wholly owned a partnership, Dunn, TC Memo 2022-112, 11/29/22, the Tax Court denied losses because neither spouse met the requisite tax law test.  

Generally, investors in activities such as real estate in which they don’t materially participate can only take deductions up to the amount of their passive income for the year.  Thus, they can’t claim any annual passive activity loses (PALs), although there’s a limited PAL write-off for real estate investors qualifying as “active participants.”  

Normally, you can use up to $25,000 of loss to offset non-passive income if you are an active participant. But the $25,000 offset is phased out for a modified adjusted gross income (MAGI) between $100,000 and $150,000 of MAGI. Note: This phase-out provision is not indexed for inflation.

A trade or business activity isn’t a passive activity if you materially participated in the activity.

Material participation tests. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

  1. You participated in the activity for more than 500 hours.
  2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
  3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
  4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
  5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
  6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years.
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. You didn’t materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if:
    1. Any person other than you received compensation for managing the activity, or
    2. Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).

Real Estate Professional - However, if your real estate activities rise to the level of being a real estate professional, you can deduct a loss against non-passive income, just like any other business. There are two key requirements for qualifying as a real estate pro.

  1. 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.
  2. You must spend more than 750 hours on your real property trades or businesses.

As long as you satisfy this two-part test, real estate activities in which you materially participate aren’t treated as passive activities.

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