Since 1986 the tax law has been unkind to real estate rental losses. Such losses are normally “passive,” meaning they can only be deducted to the extent of other “passive income,” with limited exceptions. In 1993 Congress decided this was a bit harsh on folks who made their living in real estate. As a result, rental losses of “materially participating real estate professionals” aren’t automatically passive. Instead they are treated like other activities — passive or non-passive depending on the extent the taxpayer participates in the business.
To be a real estate pro under these rules, you have to pass two tests:
- You have to work at least 750 hours in real estate trades or businesses where you are an owner, and
- You have to work more in real estate than in all of your other jobs.
Clearing this tough hurdle isn’t enough. This only makes it possible to have non-passive real estate rental losses. You also have to materially participate in the rental real estate business. You can find all of the rules here, but the most common ways to qualify are to work 500 hours in real estate rental (usually by electing to combine activities in a Section 469(c)(7) election) or by working at least 100 hours in an activity, and more in that activity than anyone else.
Yesterday a taxpayer got through the first hurdle of showing that she was a real estate pro — a full time real estate broker — , but stumbled over the second. She couldn’t prove that she spent enough time on the rental activities to “materially participate” in them. From the Court:
Moreover, although we found petitioners to be generally credible, the Court is not bound to accept as gospel the unverified and undocumented testimony of a taxpayer…
In sum, on the record before us, we are unable to conclude that petitioners have proven that [the taxpayer] materially participated in either of petitioners’ rental real estate activities.
Had she kept a daily record of the time spent on the rental properties, the result might well have been different. It was a problem of proof — the Court said the issue was close enough that it declined to impose penalties.
If Obamacare survives its court challenge, timekeeping will be an issue for many more taxpayers. The ACA imposes a 3.8% tax on high income taxpayers who have income from passive activities — real estate or otherwise. That means taxpayers will be wanting to show that they are “materially participating” in their K-1 income to avoid the 3.8% hit. Just as with the taxpayer here, they will be responsible to demonstrate their participation — so in close cases, many will want to get into the habit of tracking their time.
So what is the filing season tip? Not all real estate losses are passive. Even the taxpayers in this case might have been able to use a limited “active participation” exception that allows taxpayers with adjusted gross income under $150,000 to deduct up to $25,000 in rental losses. But having good records is a must.
Anthony Nitti has more.
Cite: Manalo, T.C. Summ. Op. 2012-30