Using the Real Estate Professional Loophole

[Diane Kennedy]

The rule of thumb for real estate losses is that you get to deduct up to $25,000 of real estate losses against other income if you make under $100,000. You need 'active' participation too - that means 100 or 200 hours per year.

If you make over $150,000, the deductible amount is zero. Deduction phases out between $100,000 and $150,000.

You can deduct if you're a real estate professional with material participation no matter how much the loss is and no matter how much you make.

There are two requirements to getting the real estate professional deduction:
(1) You have to qualify as a real estate professional. That means you have more hours in real estate activities than any other trade or business and it means that you have at least 750 hours.

(2) You have to materially participate in the properties. That means 500 hours per property per year. You can get around that if you aggregate the properties with an election you make on your tax return. If you make that election, then you only have to prove 500 hours in TOTAL.

[jeffinca]

Can you elaborate on the "make the election in your tax return" for being a real estate professional, please?

I'm a real estate broker and had 12 rental properties (two of which were really held for production of income (appreciation potential) rather than rental - one rented briefly and the other not at all.)

I had huge losses which created a NOL carried from year to year, not limited by the $25,000 passive loss limitation since I'm in the business of real estate. I'm a bit worried since I made no statement of election in my tax return regarding this topic.

Ironically, perhaps it's better that I use the carry-forward to keep my NOL lower and postpone the losses through the carry-forward rather than the NOL since NOL's expire after 20 years (federal) and 10 years (in CA).

Similarly, I elected to use 40 year S/L depreciation so that my non-recaptured § 1250 deduction recaptured in the year of disposition (foreclosures in 2008) would be smaller than 27.5 year S/L.

Do I need to make some sort of statement of election in my tax returns? I've never seen that before. I really appreciate your great advice in this forum. It's very on point for my situation.

[Diane Kennedy]

There are two places that you need to make a special notation if you're taking the REP status.

The first one is pretty obvious - it's on the bottom on page 2 of Schedule E. (Still I'm amazed at how many people miss it)

Second, you need to make an election to aggregate if you want to only have to meet one standard for material participation.

A sample election would be:


Pursuant to Reg. 1.469-9(g)(3), the taxpayer hereby states that it is a
qualifying real estate professional under IRC Sec. 469(c)(7), and electsunder section 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.

This would be attached to your tax return on a separate sheet.

[jeffinca]

Pursuant to Reg. 1.469-9(g)(3), the taxpayer hereby states that it is a qualifying real estate professional under IRC Sec. 469(c)(7), and elects under section 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.

This would be attached to your tax return on a separate sheet.

Hi, Diane.

Thanks so much for the sample language. That's a huge time-saver!

So if I just filed my 2006, 2007, and 2008 tax returns (all at a loss so no penalties), with a number in the last box of Page 2 of Sch E, but lacking the above statement of election, should I now mail in the election? Does the presence of a number in that box and the presence of 12 rental properties reasonably imply the election since it would be physically impossible not to aggregate?

I could certainly mail in an election for each year. If so, would a 1040X Amended return be appropriate or just a letter making the statement of election?

Thanks for your help!

Jeff

[Diane Kennedy]

The aggregation election has to be made with the original tax form. There's nothing you can about the past ones, but definitely make the election from here on out.

[wburns]

I'm a licensed real estate broker, who was advised by my cpa tax preparer that we are not eligible for deductions of depreciaton and expenses on rental properties due to a combined active income level above $150,000. I was told the deductions would be "deferred" until we sold any rental properties. For this reason, I have passed up many great rental property prospects.
I have been researching tax laws regarding Real Estate Professionals. Do I understand correctly that we can offset our tax liability with rental properties because I am an active, full time (overworked) real estate broker? Also,what are the consequences when we go to sell the rental properties?
My soap box moment - I'm sick of hearing about the "wealthy" getting so many tax breaks. All I know is that we make enough to be shut out of every possible American tax break but apparently not enough for supposed "loopholes"

[wayside]

You have to meet one of the material participation requirements in order to use this loophole:

1. The taxpayer works 500 hours or more during the year in the activity.
2. The taxpayer does substantially all the work in the activity.
3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
4. The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
5. The taxpayer materially participated in the activity in any 5 of the prior 10 years.
6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

These tests are *per property* unless you aggregate.

Test 1 is nearly impossible to meet on a per-property basis unless you aggregate. Test 2 is somewhat nebulous, I've never seen the definition of "substantial" anywhere; my personal interpretation is "> 50%", but I have no legal basis for this. Test 3 is pretty easy to meet if you do most of the work - if you are doing renovations or major repairs you need to keep your eye on how much time each worker spends on your property.

Keep in mind that hours your spouse spends working on your rentals count as time towards meeting the tests, even though he is not the RE professional. (This is how we pass the test - my wife is the RE pro and I do most of the maintenance and repairs). Time spent traveling to and from the properties does not seem to count either.

[Diane Kennedy]

Thanks for the detailed answer Charlie.

[raxitrei]

That is a great deduction for real estate agents. The two requirements are just an ordinary thing for agents to have. Some tax return should be making on earlier period to prevent some unnecessary things.

[steven76]

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