The tax and accounting professionals at Berman Goldman & Ribakow explain the tax implications on passive vs non-passive real estate income.
Generally, a passive activity is any rental activity or any business in which the taxpayer does not materially participate. Rental activities include real property rentals, personal property rentals, and rentals of intangibles (if the taxpayer did not significantly contribute to the creation of the intangible). Businesses in which the taxpayer does not materially participate include interests in closely held businesses, publicly traded partnerships, and limited partnerships. Non-passive activities are businesses in which the taxpayer is a continuously active participant. In addition, passive income does not include salary, portfolio, or investment income. Passive losses can only be deducted against passive income, but not below zero for the rental activity. Non-passive losses can fully be deducted which can result in a loss in the activity. This impacts how much taxable income will be on the tax return.
Ordinarily, passive activity loss rules treat rental real estate as a passive activity. Since passive losses can only offset passive income, rental losses that exceed passive income will be suspended and can only be deducted in a future year when there is net passive income to apply the suspended loss against, or if the property is sold. For 2016, if the taxpayer actively participated in a passive rental real estate activity, then a special allowance of $25,000 can be offset to non-passive income. However, if the taxpayer reported as married filed separately (MFS), he or she is not permitted to use the special allowance. If the taxpayer’s adjusted gross income (AGI) is over $100,000 then the allowance is reduced by 50%. This phase-out does not apply if the low-income housing tax credit applies to the property.
Active participation is not the same as material participation. Active participation is less stringent compared to material participation. A taxpayer is considered to actively participate when they make management decisions to a certain extent. These management decisions include but are not limited to approving new tenants, deciding rental terms, and approving expenditures.
Grouping separate business activities to treat them as a single activity is permitted. In doing so it is important to remember that this does not apply to all business/trade/rental activities. Certain activities cannot be grouped, such as a publicly traded partnership (PTP) or limited partnerships (LP). The economic unit is based on facts and circumstance. In addition, real property rentals cannot be grouped with personal property rentals.
Passive losses can be fully allowed in the tax year if the taxpayer disposes their entire interest in the passive activity. An exception to this rule is if the person acquiring the interest from the taxpayer is related to the taxpayer.
A real property trade or business is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. The taxpayer must continuously engage in one or more of the activities mentioned above for their actions to be classified as a non-passive activity.
If a taxpayer is considered a real estate professional, he or she gains the ability to offset rental real estate losses against ordinary and portfolio income. At times, passive losses of certain closely held corporation may offset an active income.
To qualify as a real estate professional, one must meet three requirements of material participation:
- 50% of the taxpayer’s services during the tax year are performed in real property trades or businesses in which the taxpayer materially participates
- The taxpayer must complete over 750 hours of service during the tax year in real property business in which he or she materially participates
- The taxpayer must participate materially in the real estate activity
For additional information or to consult with a skilled tax professional, please contact the experienced professionals at bgr CPAs today.