Because of the recent boom in real estate, many individuals have jumped back into the real estate market and have become landlords. Renting real estate can generate significant tax losses. Anyone considering utilizing losses realized in the real estate market to offset other sources of income such as wages, must be aware of the tax laws limiting real estate losses. This article will discuss the two potential ways an individual taxpayer can utilize real estate losses to offset income such as wages.
1. The Small Landlord Exception and the $25,000 Special Allowance
Generally, real estate activities are considered passive activity for tax purposes. This means that losses incurred from real estate activities are not typically deductible against other sources of nonpassive income such as wages. However, in certain cases, up to $25,000 in passive losses from real estate losses can be deducted for each year against nonpassive income such as wages. In order to claim up to $25,000 the following limitations apply:
- The taxpayer must “actively participate” in the real estate rental activity. Active participation standards are met if the taxpayer owns at least 10 percent of the rental property, and has substantial involvement in managing the rental property (defined as the taxpayer spending more than 500 hours at the activity and no one else spends more hours than the taxpayer claiming the loss).
- The $25,000 special loss allowance is phased out by 50 percent of the taxpayer’s modified gross income that exceeds $100,000. It reaches zero by the time the taxpayer’s income hits $150,000. Therefore, this limitation may not be available for taxpayers in relatively higher income tax brackets.
If a taxpayer satisfies the above-mentioned rules, he or she may qualify for annual losses up to $25,000 associated with real estate activities. Even if a taxpayer believes that he or she may qualify to take the $25,000 loss, it is extremely important that he or she keep a contemporaneous log of all applicable real estate activities. A log may be the only way a taxpayer can substantiate his or her participation in the real estate rental market to the IRS in the event of an audit.
2. Real Estate Professional Deductions, What You Need to Know
In certain cases, a taxpayer can be classified as a real estate professional. Individuals who meet the so-called real estate professional eligibility requirements are able to use all of their losses from the real estate activities as deductions against ordinary income such as wages or salaries. The $25,000 rental loss limitations do not apply to real estate professionals. In order to be classified as a real estate professional, a taxpa yer must satisfy the following requirements:
- The taxpayer must materially participate in the real estate rental activity. Material participation requires that the taxpayer be involved in the operations of the real estate rental on a regular, continuous, and substantial basis.
- In addition, more than 50 percent of the individual’s personal services during the calendar year at issue are performed in real estate. In other words, a taxpayer must spend more time in a trade or business of renting real estate than in any other professional trade.
- Finally, the individual should spend more than 750 hours during the calendar year performing real estate rental activities.
Clearly, being a real estate professional for tax purposes can be extremely advantageous from an income tax point of view. However, anyone considering classifying themselves as a real estate professional for tax purposes must be prepared to substantiate that they materially participated in the trade or business of real estate and that they spent more than 750 hours a year in real estate services. Perhaps the best way to prove eligibility to be classified as a real estate professional would be by preparing contemporaneous time logs. What should such a log contain? At a minimum, a real estate log should provide a detailed narrative summary of each and every activity performed in the rental of real estate. For example, time spent on advertising, maintenance of property, and billing should be itemized and carefully recorded. Although preparing a contemporaneous real estate log may seem cumbersome and tedious, a good real estate log is invaluable should the IRS challenge such a deduction.