3 Ways Real Estate Investors Can Avoid the Passive Activity Loss Limitations Rules by Angie Adames, CPA
Posted on June 01, 2022
One of the most basic tenets of tax efficiency is tax-loss harvesting, or the practice of selling underperforming investments and creating a capital loss that you can then use to offset capital gains and ultimately reduce the amount of income subject to tax. Despite the simplicity of this concept, there is a myriad of complexities that taxpayers must consider to minimize tax exposure, especially when you operate pass-through businesses and/or generate interest income, dividends and capital gains from real estate investments. Under these circumstances, protecting your income requires an understanding of the passive activity loss (PAL) rules.
While the tax laws generally allow deductions for losses, Section 469 of the Internal Revenue Code restricts taxpayers from using losses generated from passive activities to offset ordinary income they earn from non-passive trade or business activities in which they materially participate on a “regular, continuous and substantial” basis. In other words, if you are an investor who is not regularly and continuously involved in the operations of a trade or business, you may not use that business’s losses to offset salary and other income you earn from sources in which you materially participate. Consequently, you must take the time to separate your income-generating activities into two groupings: passive and non-passive.
The IRS defines a passive activity as either:
- a trade or business activity in which the taxpayer does not materially participate during the year, or
- a rental activity (regardless of material participation unless the taxpayer is a real estate professional.)
Because the losses from rental real estate activities are “per se” passive, they typically can only be deducted to the extent you have passive income from other sources. Should your passive losses exceed passive income in a given year, the PALs rules require you to suspend them temporarily and carry them forward to be used in a future year when you either have passive income or when you sell the property that initially generated those passive losses.
Can You Prove Material Participation?
An exception to the PALs rules exists when you can establish “material participation” on a “regular, continuous and substantial” basis. Doing so requires you satisfy any one of the following tests:
- You participated in the activity for more than 500 hours during the year (or approximately 10 hours per week,)
- Your participation for the year constituted substantially all of the work conducted by any other individuals,
- Your participation for the year exceeded 100 hours and was not less than any other individual’s participation in the year
- The activity was a “significant participation activity” (SPA), or a trade or business activity for which you worked a minimum of 100 hours during the year, and your aggregate participation in all SPAs during the year exceeded 500 hours,
- You materially participated in the activity for five of the prior consecutive or non-consecutive 10 years,
- The activity is a personal service for which you materially participated for any of the three prior consecutive or non-consecutive tax years, or
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
It bears repeating that you need to meet just one of these seven tests to demonstrate material participation and qualify to offset active income with losses from otherwise non-passive activities.
Are You a Real Estate Professional?
Code Section 469 carves out a special exception for real estate professionals whose net losses on rental real estate are generally limited to $25,000, which is phased out when adjusted gross income exceeds $100,000. However, a taxpayer with rental income may escape the passive activity loss limitations if he or she can meet the following criteria to qualify as a “real estate professional”:
- More than half of the personal services you performed during the year were in connection with a real property trade or business in which you materially participated, and
- You spent more than 750 hours during the tax year working in a real property trade or business in which you “materially” participated.
Can You Aggregate Your Real Estate Rental Activities?
The PALs rules can be further complicated when you engage in multiple rental real estate activities. For example, if you own three rental properties, A, B and C, the IRS generally requires you satisfy a separate material participation test for each individual property to bypass the passive activity loss rules. However, you may make an election to treat multiple rental real estate activities as one economic activity to satisfy the time requirements for proving material participation. This may also simplify your tax-reporting requirements, enabling you to combine gains and losses from grouped activities and thereby improving tax efficiency across your portfolio of properties. Grouping together real estate activities to avoid the PAL rules requires keen attention to detail and comprehensive documentation to substantiate your claims.
While the IRS does not require taxpayers to maintain contemporaneous documentation of their time participating in business and real estate activities, it is prudent to keep reasonable records, considering the recent rise in audits involving claims of non-passive activities. The burden of proof falls on the taxpayers, who should review their passive activities and consider the beneficial and potentially negative tax implications of proving material participation, qualifying as real estate professionals or making grouping elections. Actions taken today may have far-reaching effects in later years.
About the Author: Angie Adames, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where she provides tax and consulting services to real estate companies, manufacturers and closely held entities. She can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at firstname.lastname@example.org.