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July 12, 2017

Becoming a Real Estate Professional for the Passive Activity Loss Exception

As renting becomes more common than buying, more individuals are renting out properties and are earning income and accruing losses from their rental activities. As tax attorneys in Columbus, Ohio, we assist many individuals and businesses that become subject to an Internal Revenue Service audit or examination. Below is an overview of the real estate professional exception to the passive activity loss rules. The tax lawyers at Nardone Limited assist Ohio taxpayers on understanding the real estate professional exception and can provide guidance on how to successfully be considered a real estate professional for purposes of the passive activity loss rules.

Passive Activity Loss Rules

The passive activity loss rules typically limit the amount of passive losses than can be currently deducted. Rental real estate is automatically classified as passive for the purposes of this rule. Therefore, losses from rental real estate are not currently deductible, unless an exception applies. There is a statutory exception that allows up to $25,000 of passive rental real estate losses to be currently deducted. But, the $25,000 exception is only available if the taxpayer’s adjusted gross income is less than $150,000 and the taxpayer meets certain other requirements. The statutory exception does not reclassify rental real estate losses as active, however.

Real Estate Professional Rule

In general, the real estate professional rule provides an exception from automatically classifying rental real estate as passive. Rental real estate losses are not automatically considered active if the taxpayer is considered a real estate professional. Instead, a real estate professional is allowed to use one of seven material participation tests to determine if their rental activity should be classified as active or passive. A real estate professional who is able to classify their rental real estate as active can deduct losses currently, which is a huge benefit to the taxpayer as they can use these losses to offset their ordinary income.

Real Estate Professional Determination

To be considered a real estate professional, a taxpayer must first perform personal services in a real property trade or business in which they materially participate. The hours a taxpayer works in the real property trade or business must exceed their other business hours, and must also exceed 750 hours. A real property trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. The hours a taxpayer works as an employee of such a trade or business do not count unless the taxpayer is at least a 5% owner in the trade or business. Once a taxpayer is considered a real estate professional, the taxpayer must look at each rental property interest separately and apply one of the material participation tests in order to characterize that property as active or passive. A real estate professional can group all rental property together for this determination only if they file a formal election with the IRS.  

Nardone Limited Comment: Taxpayers need to be aware of the complexity regarding the real estate professional determination. The rule sounds very easy. But, the Internal Revenue Service will closely scrutinize the taxpayer’s activities, and strictly construe those against the taxpayer. The taxpayer must have very detailed records supporting the activities and documenting the taxpayer’s hours and participation in those activities. In handling many IRS examinations and audits, rarely do we find taxpayers that properly document their involvement in real estate activities. We have litigated this issue in the United States Tax Court, and the Tax Court judges and the Tax Court itself, will strictly construe this exception, as well. Thus, taxpayers must be proactive and work with their tax professionals on the front end of preparing their tax return. That is, if you intend to make the election regarding the real estate professional exception on your 2017 tax return, do not wait until 2018, when you intend to file your return, to begin that documentation.

Contact Nardone Limited

Nardone Limited frequently represents individuals and businesses in federal tax matters, including the real estate professional exception. If the IRS, Ohio Department of Taxation, or other taxing authority has contacted you or your business to be audited or examined, do not go at it alone.  You should contact the tax attorneys at Nardone Limited.  We have vast experience representing individuals and businesses in IRS audits, exams, appeals, United States Tax Court, and other courts.  Contact us today for a consultation. 

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July 12, 2017

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