Real Estate – Is It Time to Invest?

During this economic downturn, we have seen housing prices and mortgage interest rates fall. The stock market keeps falling and setting new lows. The combination of these events may have people looking to get into the real-estate market for investment purposes.

While there are many things to consider when making such an investment, the possible tax benefits should be at the end of the list. Generally, rental real estate generates a tax loss that may or may not be deducted on the individual tax return. There are rules that may disallow or limit the losses from rental activities and limit the tax benefits of such investments.

Passive Activity Rules

The biggest hurdle in deducting rental losses is the passive activity rules. While real estate might be our current focus, it’s important for us to have an overall understanding of these rules and how they are intended to work. The passive activity rules were set up by Congress in 1986 to curb the abuses of tax shelters aimed at individuals. The Internal Revenue Code generally does not allow the taxpayer to deduct a loss or credit from a passive activity.

If there is passive income during the year, it is allowed to be offset against the passive losses for the year. Any excess passive losses that were not offset by passive income are carried over to the following year. If the passive activity is fully disposed of in a taxable transaction, the passive losses that were carried over are allowed to be deducted in the year of disposition.

Rental activities by their nature are passive activities. Any rental activity, generally, is considered a passive activity. There are six exceptions to this rule:

1. The average period of customer use for such property is seven days or less, as with a rental-car company.

2. The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers (e.g. hotels).

3. Extraordinary personal services are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use). An example of this exemption might be the rental of crutches from an orthopedic physician practice.

4. The rental of such property is treated as incidental to a non-rental activity of the taxpayer. This includes property held for investment, and the gross rent received is less than 2% of the lesser of the unadjusted basis or the fair market value in the building (rental of land to a logger, for instance).

5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers, such as with a parking garage.

6. The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity. For example, a lawyer renting an office building to his or her own practice would fall within this exception.

If the taxpayer is involved in any of the activities noted above, the loss from the activities would not be considered passive. Rather, the losses would be deducted and would not have to meet the passive-activity loss limitations.

The IRS provides an exemption for middle-class taxpayers that allows a $25,000 deduction on certain residential rental activities. The taxpayer must actively participate in the rental activity during the tax year. In other words, the taxpayer must make management decisions, such as approving tenants and arranging for repairs, in a bona fide sense. This exemption is reduced by 50% of the amount of adjusted gross income (AGI) over $100,000 and is fully phased out once AGI reaches $150,000.

There are also special rules for taxpayers in the real property business or real-estate professionals. A taxpayer that is determined to be in the real property business may elect to not be subject to the passive activity rules. A taxpayer must materially participate in the rental activity to be in the real property business. For a taxpayer to materially participate in the real property trade or business, he or she must spend more than one-half of his or her time and more than 750 hours of service during the year in the real-estate business. To be considered a real-estate professional, the taxpayer must ‘materially participate’ (see below) in the real estate activity and not just merely ‘actively participate’ in it. Real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

A passive activity can also be any activity that is a trade or business that the taxpayer does not materially participate in. Material participation occurs when the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial. Any work that an owner performs for his or her business is generally considered participation. Material participation is determined on a yearly basis.

Once a taxpayer is considered to materially participate in an activity, it does not mean that he or she will continually be considered to materially participate the next year. If the taxpayer materially participates, the loss generated by these activities would not be considered passive, and the taxpayer would be able to deduct the losses without having the passive-loss rules come into play.

Keeping the above in mind, make your real-estate investment decisions based upon the economics of the investment without considering the possible tax benefits. Under the passive-loss rules, those benefits could be a long time in the making.

Sean Wandrei is a tax manager with Meyers Brothers Kalicka, P.C. His technical concentrations are in multi-state taxation as well as real-estate entities; (413) 536-8510.