Are Your Losses From Real Estate Limited?

Information the real estate investor should know before filing a 2013 income tax return.

Owning investment property can provide many benefits and tax incentives. However, several pitfalls exist for the unwary real estate investor expecting to take losses from real estate investments and offset ordinary income from their full time employment or a flow through entity such as an S corporation, limited liability company or partnership.

In reviewing your tax returns with your tax preparer, you should consider these common issues to ensure you properly report losses and income derived from your real estate investments.

Self Rental Rule:

Question: What tax treatment do real estate investors have when they rent commercial property to a business they materially participate in?

Answer: If you own commercial property, or any property that is not your dwelling, and you rent the property to a business that you materially participate in, the Internal Revenue Service can recharacterize net rental income as non-passive income (active income). Your net losses, however, will remain passive.

Generally, you are allowed to offset passive income with passive losses. Active net income (i.e. from wages, sole proprietor business, etc.) can only be offset with non-passive losses from other non-passive activities.

The effect of the Self Rental Rule is to increase your ordinary income without offsetting losses from other real estate investments you may have.

A typical scenario: you own a business and also own the building. The building is owned by you individually and is rented to your corporation, which operates the business. This can trigger the self-rental rule.

One solution would be to have the entity operating the business also own the real estate.

Vacation rentals:

Question: Can you deduct losses from a vacation rental?

Answer: the answer depends on how frequently you rent out that unit.

Any dwelling unit (i.e. house, apartment, condo, vacation cottages, mobile home, boat, etc.) that you rent on average 7 days or less is treated as a business. You can think of this similar to a weekly rental that is short term where renters do not stay for an extended period.

For these short term rentals, they are treated as a business and reported on a Schedule C (for sole proprietor businesses – no business entity).

If you have a rental unit that is on average more than 7 days (i.e. extended stay rented for the summer or a month at a time), these rentals will be reported on Schedule E where income and losses from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in REMICs are reported.

Net losses from real estate activities are generally passive unless the taxpayer materially participates (i.e. manage the day-to-day activities by collecting rent, hiring contractors to perform repairs, etc.). In other words, having a management company manage the property, collect the rent, evict tenants, and handle the business affairs may preclude a finding that you are materially participating in this rental activity.

There are two general exceptions to the real estate passive activity rule. The first is the Real estate professional exception and the second is the $25,000 rule.

Real Estate Professional Exception:

To qualify for the real estate professional exception, you do not have to be a licensed real estate sales person or broker. What is required is the following:

  1. More than half of all your time in a trade/business that is devoted to real estate trade or business and
  2. You devote more than 750 hours per year in a real estate trade or business that you materially participate in.

If you have multiple properties, you may be able to elect to group them as one economic activity to satisfy the test for all properties.

"Real Property trade/business" means

  • Development
  • Redevelopment
  • Construction
  • Reconstruction
  • Acquisition
  • Conversion
  • Rentals
  • Operation
  • Management
  • Leasing
  • Brokerage

$25,000 Exception:

  • This exception permits a taxpayer to offset up to $25,000 of non-passive income against losses from rental real estate activities. The taxpayer must actively participate in managing the real estate (a far lower standard than material participation). "Active participation" requires that you are making the management decisions versus hiring a management company to manage your property.

A couple limitations:

  • The $25,000 ceiling is phased down to zero as the taxpayer's AGI increases from $100,000 to $150,000.
  • The exception only applies to natural persons (not corporations).

The information contained in this article is presented only for information purposes and may not be relied on as legal advice or construed as developing an attorney client relationship. If you need legal advice you should contact an attorney.

Call our San Diego tax lawyer for more information.

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