Investors may purchase rental real estate for several reasons, but one of the primary motivations is often the potential for long-term property appreciation. In some cases, rental property also generates positive cash flow, providing income in addition to the possibility of increased property value over time. However, rental real estate can also generate losses, particularly when expenses such as interest, repairs, depreciation, insurance, and property taxes exceed rental income. Investors may feel comfortable with some level of annual loss if they believe the property’s value will appreciate over time or if the losses can offset other income they are earning. From a tax perspective, however, the ability to currently deduct those losses is not always straightforward. Investors should understand the tax treatment of rental real estate and the limitations imposed by the Internal Revenue Code (IRC).
How IRC Section 469 Limits Rental Real Estate Losses
By default, rental real estate is generally treated as a passive activity for federal income tax purposes. Under IRC §469, passive activity losses generally may only be used to offset passive activity income, which would not include income such as wages, materially participating business income, investment income, or other nonpassive income. If rental real estate losses exceed passive income for the year, the unused losses generally are disallowed and carried forward to a future tax year. Those suspended losses may become deductible in a later year when the taxpayer has passive income or, in some cases, when the taxpayer disposes of the activity. As a result, rental real estate losses may have limited current tax benefit unless the taxpayer qualifies for an exception to the passive activity rules.
Insight from Forvis Mazars: Certain taxpayers may be able to deduct up to $25,000 of rental real estate losses against nonpassive income. However, this allowance is subject to income-based phaseouts and is generally unavailable once modified adjusted gross income reaches certain thresholds.
When Rental Real Estate Losses May Be Treated as Nonpassive
An exception may apply to taxpayers who qualify under the commonly referred to “real estate professional” rules. If the requirements are met, rental real estate activities are not automatically treated as passive. Instead, the taxpayer may be able to treat rental losses as nonpassive, provided the taxpayer also materially participates in the rental activity or properly grouped rental activities.
To qualify under the real estate professional rules, a taxpayer generally must satisfy both of the following annual tests:
- More-than-half test: More than half of the total time the taxpayer spends working in all trades or businesses during the year must be spent in real property trades or businesses in which the taxpayer materially participates.
- 750-hour test: The taxpayer must perform more than 750 hours of services during the year working in real property trades or businesses in which the taxpayer materially participates.
For this purpose, real property trades or businesses generally include activities involving the development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property. Time spent merely as an investor generally does not count, and services performed as an employee generally do not count unless the taxpayer owns at least 5% of the employer.
Material Participation Rules for Rental Real Estate Losses
Qualifying under the real estate professional rules is not enough by itself. The taxpayer must also materially participate in the rental real estate activity, or in properly grouped rental activities, for the losses to be treated as nonpassive.
A taxpayer generally may establish material participation by meeting one of the following tests:
- More than 500 hours: The taxpayer participates in the activity for more than 500 hours during the year.
- Substantially all participation: The taxpayer’s participation represents substantially all of the participation in the activity by all individuals for the year.
- More than 100 hours and no less than others: The taxpayer participates for more than 100 hours during the year, and no other individual participates more than the taxpayer.
- Significant participation activities: The activity is a significant participation activity, and the taxpayer’s total participation in all significant participation activities exceed 500 hours for the year.
- Five of the prior 10 years: The taxpayer materially participated in the activity for any five of the preceding 10 tax years.
- Certain personal service activities: For certain personal service activities, the taxpayer materially participated in the activity for any three prior tax years.
- Facts and circumstances: Based on all facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis.
Because these tests are fact-specific, contemporaneous records showing the time spent and the nature of the work performed can be important in supporting material participation.
Insight from Forvis Mazars: The material participation rules are used in other contexts of the IRC and are not only used to decide if a taxpayer qualifies as a real estate professional. As a result, some of the material participation tests may be less relevant in a rental real estate context than others. For example, the personal service activity test generally applies to certain service-based businesses, not typical real estate rental activities. Even so, understanding the full set of tests can help taxpayers and their advisors determine whether rental losses may be treated as nonpassive when the real estate professional rules are otherwise satisfied.
How the Real Estate Professional Rules Apply to Married Taxpayers
For married taxpayers, the real estate professional tests are applied separately to each spouse. One spouse must independently satisfy both the more-than-half test and the 750-hour test for the rental real estate activities. A married couple generally may not combine their hours or participation to meet these two tests.
If one spouse satisfies the real estate professional tests, the taxpayer still must materially participate in the rental real estate activity, or in properly grouped rental activities, for the losses to be treated as nonpassive. Unlike the real estate professional tests, both spouses’ participation generally may be counted for purposes of determining material participation.
For example, one spouse may work full time and receive a W-2 for wages earned while the other spouse spends more than 750 hours managing the couple’s rental properties and spends more time on those rental activities than on any other trade or business. In this case, the spouse managing the rentals may satisfy the real estate professional tests. The couple then would still need to determine whether there is material participation in the rental activities, considering both spouses’ participation and any applicable grouping election.
How Forvis Mazars Can Help
The tax treatment of rental real estate losses depends on a taxpayer’s specific facts, including time spent, ownership structure, participation in the activity, and supporting documentation. Professionals at Forvis Mazars can help investors evaluate whether the real estate professional and material participation rules may apply, assess whether grouping rental activities may be appropriate, and identify records needed to support the taxpayer’s position. If you own rental real estate or are considering additional investments, contact one of our tax professionals to understand how these rules may affect your tax planning strategy.