Individual investors like you and your neighbor account for almost 75% of rental properties in the United States according to the U.S. Census Bureau’s 2015 Rental Housing Finance Survey. So how do we determine who’s a “professional” in the real estate world, and more importantly why do we care?
Real estate has countless tax advantages that often start to build up tax losses, and for someone who doesn’t qualify as a real estate professional, these tax losses are deemed to be passive losses. A taxpayer may offset losses from a passive activity against income from a passive activity. A passive activity generally includes any trade or business of a taxpayer in which the taxpayer does not materially participate and any rental activities of a taxpayer, regardless of the level of participation. However, if you qualify as an active investor and you have less than $150,000 of adjusted gross income then you’re able to deduct up to $25,000 of real estate losses.
As a qualified real estate professional, the rental activity is not presumed to be passive and will be treated as nonpassive if the taxpayer materially participates in the activity. This means that these real estate losses will allow the losses to be offset without limitation from any other income which you may have.
There are three categories which the IRS uses to classify real estate investors:
- Passive investors: This is the least beneficial category and as mentioned above only allows passive losses with real estate as mentioned above to be used to offset passive gains. This designation means that you are not actively involved in the real estate investing, typically this designation means that you’ve put capital into a deal, however someone else is managing everything and you simply receive a return on your investment.
- Active investors: This designation allows us to deduct up to $25,000 of losses against ordinary income, however, it is phased out completely at $150,000 of adjusted gross income a year (for a married couple filing jointly or $100,000 for an individual). This is a designation when you actively are managing the property and involved, however, do not qualify as a real estate professional (noted below in #3).
- Real Estate Professional: 100% of all real estate losses are deductible here against ordinary income. A taxpayer qualifies as a real estate professional if:
- a. the taxpayer spends more than one-half of the services the taxpayer performs in trades or businesses during the tax year in real property trades or businesses in which the taxpayer materially participates, and
- b. the taxpayer must spend 750 hours or more in the real property business and rentals in which he or she materially participates
by Michael Abramowitz, CVA, Senior Consultant