Investing in real estate is a great way to build wealth over time and make passive income. But understanding taxes, especially when it comes to deducting losses from rental properties, can be tricky. One of the biggest challenges for real estate investors is figuring out the difference between “passive” and “non-passive” income. Luckily, there’s a rule that allows real estate professionals to take advantage of significant tax deductions. Let’s break it down.
Why It’s Hard to Deduct Passive Activity Losses
According to tax rules, losses from passive activities, like rental real estate, can usually only offset other passive income. If your rental losses are bigger than your passive income, the extra losses are carried over to future years. This rule can be a problem for real estate investors who are actively managing their properties, because the IRS still treats rental income as passive, even if you’re working hard at it.
However, there’s an important exception for those who qualify as a real estate professional according to the IRS guidelines. This allows you to treat your rental activities as non-passive, which means you can deduct your rental losses from other types of income (like your salary or business profits). This can help lower your taxable income and give you more cash flow.
Why Being a Real Estate Professional Matters
Before 2013, the main benefit of qualifying as a real estate professional was that you could offset rental losses against non-passive income, reducing your overall tax bill. But with the introduction of a new tax, called the Net Investment Income Tax (NIIT), things got a little more complicated. The NIIT is a 3.8% tax on passive income, including rental income. But, by qualifying as a real estate professional, you can avoid this tax and still deduct your rental losses.
How to Qualify as a Real Estate Professional
Becoming a real estate professional isn’t automatic, it requires meeting some specific requirements. Here’s a simple guide to help you understand what you need to do:
- Classify Your Activities: Property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage activities are considered real property trade or business activities. Combining activities can help to meet the qualifications.
- Meet the Key Tests: To qualify as a real estate professional, you must meet both of the following requirements:
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
- Demonstrate Material Participation: To qualify as a real estate professional, you must show that you’re actively involved in your activities. To demonstrate this, you must satisfy one of the seven material participation tests (Pub. 925). Two common ways you can do this is by either:
- You participated in the activity for more than 500 hours.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year
- Track Your Time: Keep detailed records of how much time you spend on these activities. If you’re married and filing jointly, only the time of the spouse who wants to qualify counts.
- Material Participation in Rentals: Just being a real estate professional isn’t enough. You also need to show that you’re involved in managing your rental properties. A simple way to meet this requirement is to aggregate all your rental activities for tax purposes.
How CSA Partners Tax Services Can Help
We know that taxes for real estate can be confusing, but with the right help, you can save a lot of money. At CSA Partners, we specialize in helping real estate professionals maximize their tax deductions and minimize their liabilities. Here’s how we can help you:
- Cost Segregation Studies: We help speed up depreciation deductions, giving you more cash flow and reducing your taxes.
- IRS Compliance: We ensure your studies are accurate and compliant with IRS rules, reducing the risk of an audit.
To dive deeper into the real estate professional requirements and the material participation rules, we recommend reviewing the IRS Publication 925 – Passive Activity and At-Risk Rules. You can also learn more about Cost Segregation Studies to help maximize your depreciation deductions.
By working with CSA Partners, you can make sure you’re taking full advantage of tax benefits and making the most out of your real estate investments. We’ll be your partner in navigating the tax rules and boosting your investment success!
