There are many reasons people tend to own rental properties - investment purposes, cash flow purposes or even as part of a tax planning strategy.
Depreciation and other deductions associated with rental properties often provide taxpayers with valuable tax benefits, including generating paper losses associated with those activities. The rules regarding whether those losses can be deducted can get very complicated and difficult to navigate.
The IRS has a variety of rules related to whether taxpayers can deduct losses associated with rental real estate, but most of those limitations can be overcome if the taxpayer is able to prove he or she is a “real estate professional” in the eyes of the IRS.
The IRS has a list of criteria to help taxpayers determine if they are a “real estate professional” but the two most important are:
- More than half of the total personal services the taxpayer performs in trades or businesses is performed in real property trades or businesses in which the tax materially participates
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses.
If a taxpayer can prove these two criteria, then most likely, he or she will be able to deduct rental losses in full. However, the situation gets murkier when multiple rental properties are owned. Technically, if a taxpayer owns multiple rental properties he or she would have to meet criteria for each property, which if you look at that criteria, would be impossible to do.
Let us look at an example: John Smith has investment income and other ordinary income of $175,000, and he also owns two rental properties that each generate a $5,000 tax loss. If John spent 1,000 hours on producing his other ordinary income (say he is a marketing consultant and produced the income from consulting activities), 800 hours on Property A and 400 on Property B, then under current IRS rules John would not be able to deduct any of the losses. However, they would get carried forward and potentially deducted in a future year. This could cost John several thousand dollars a year that could be used for future investments, upgrades to the property or even his daughter’s college tuition.
The IRS does have a way around this limitation, and it comes by way of special election that has to be made on the tax return to group all rental real estate activities and treat it as one activity. Often, many taxpayers do not take advantage of these elections or don’t update them properly as they acquire new properties. This mistake can prove costly to the taxpayer.
Looking back at our previous example, if John had made the election to group his two properties into one, he would have been able to deduct his losses in full. Since he worked 800 hours on Property A and 400 hours on Property for a total of 1,200 hours - and because he worked 200 hours more on rental real estate activities than his consulting activities - he meets both criteria. This can only be accomplished by making the proper elections with the IRS when filing your tax return.
Rental real estate carries with it a lot of rules and regulations from the IRS, so it is of the utmost importance to make sure you are handling these correctly. The real estate professional election does have some drawbacks, including limitations when selling properties at a loss, which is even more reason to make sure you are having the discussion with your tax preparer and doing what is in your best interest for your specific situation.
Chad Wouters, CPA joined Earney & Company in December 2006 and became the tax partner in November 2013. With an emphasis on strategy and planning, Chad works with his clients all year to ensure the most efficient tax strategies are put into place. Earney & Company, L.L.P. is a CPA firm that handles tax compliance, consulting and planning as well as audit and other assurance services. For more information please visit www.earneynet.com or call (910) 256-9995. Chad can also be reached at [email protected].