If you have real estate and have been taking advantage of all the great tax advantages available through phantom expenses like depreciation, then you likely have run into a snag. As your income goes up, your ability to take that loss against your other income goes down.
There is an exception, if you qualify. That’s by taking the Real Estate Professional deduction. If you haven’t heard of this before, please search on this site for “real estate professional” and you’ll find a lot of information on how to legally qualify.
Today, I want to talk about taking and keeping a Real Estate Professional deduction on your tax return. It can mean big tax savings. But there are definite rules to taking this deduction. Unfortunately, some people got greedy with this tax strategy. It brought on IRS scrutiny for both people who legally took it and those who did not.
Let’s assume that everything is legal and you’ve taken the real estate professional deduction correctly. The IRS began targeting real estate professionals for audits back in 2008. They aggressively denied the deduction and some cases went on to Tax Court.
The dust has now settled on these cases and we have better guidance on what you can and can’t do. Here are some of the highlights.
New proposed regulations from late 2011 tell us that the business entity that you hold your real estate in can have a significant impact on your deductibility of real estate losses. Avoid being just a limited partner in a limited partnership or a member in a member-managed LLC. The IRS us that those structures and set-ups turns these losses into passive losses. It doesn’t matter if you are a real estate professional, you won’t be able to take any passive losses against your active income
The solution in this case is to hold a general partnership interest as well as a limited partnership interest in the LP or change your member-managed LLC to a manager-managed one and make sure you’re a manager.
The IRS has also been closely looking at what constitutes real estate activity. One of their early claims was that real estate agents could not use their activities as a real estate activity. That is even though the Code tells us that ‘brokering a deal’ was a legitimate activity. They further argued that you had to be a Real Estate Broker in order to broker a deal. The IRS was shut down on that one. The Tax Court said that a real estate agent could broker a deal and that meant that was a legitimate deduction.
Another possible concern was the need for 500 hours per property for material participation. You could aggregate the properties to avoid the ‘per property’ requirement. The IRS has loosened the need to make that election on a timely basis, allowing taxpayers to make the election after the fact. But there can be a downside to taking the aggregation election if you later sell one of the properties at a loss. You won’t be able to take that loss against other income. This could especially be compounded if you have a foreclosure or other form of debt forgiveness income involved.
This is a hotly contested area of tax law. Keep up to date on the changes! There are bound to be more coming.
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