Do you invest in rental real estate? Normally, losses from investments may be used to offset other highly taxed income, such as salary, dividends and interest. But as a general rule, you can only use losses from rental real estate activities to offset income from other “passive activities” on your tax return. Any excess losses are suspended and must be carried forward to future years.
However, this restriction doesn’t apply to real estate professionals. But there’s a catch: Even real estate professionals must pass a “material participation” test in order to use passive losses to offset non-passive income. For this purpose, professionals may elect to aggregate or treat all rental real estate activities as one activity.
In one Tax Court case, a married couple owned five apartment buildings and three single-family condos. The wife, who is also an accountant, qualified as a real estate professional. However, the couple failed to make the proper tax return election to aggregate their rental real estate activities. Therefore, the wife was required to meet the material participation test for each separate activity. Since she couldn’t meet the test individually for any activity, all of the losses were disallowed. (Jahina, TC Summ. Op. 2002-150)
If you’re not a real estate professional, you may still qualify for an extra tax break if you “actively participate” in rental real estate. In this case, you can use up to $25,000 of loss from the activity to offset non-passive income, such as salary, self-employment income, dividends and interest. This special exception is phased out for taxpayers with an adjusted gross income of between $100,000 and $150,000.
How do you “actively participate” in a rental real estate activity? Participation must be significant and legitimate from a business perspective. For instance, you might make management decisions, approve new tenants, handle repairs and so on. However, simply listing yourself as a real estate manager or rental agent isn’t sufficient.
What if the rental property you own is being used by your business? That was the issue decided in another Tax Court case.
The details: Gary and Delores Beecher owned a company specializing in repairs of automobile interiors. They rented a portion of their California home as an office to their corporation. Then the couple offset the rental income by the losses from other rental properties they owned.
However, the IRS argued, the net income from the home rental was non-passive income under the tax law’s “recharacterization” rule. Reason: The Beechers materially participated in the business activity of the corporation leasing the space.
The court agreed with the IRS on this case. Therefore, the net income from the office rental could not be offset by passive losses from other rentals. (Cal Interiors Inc., TC Memo 2004-99)
Toward the end of the year, you may need to offset income from passive activities or generate passive income to absorb losses from passive activities. In either event, seek expert tax advice with respect to your situation.