Rental Real Estate & the Passive Activity Rules
More and more Americans are investing in real estate due to the appreciation of real estate markets in the past few decades. The real estate tax rules are complex. This complexity causes a number of taxpayers to not realize the full tax benefits associated with their real estate investments. This article will briefly address the passive activity limitation rules as they relate to rental real estate investments and it will point out some basic planning opportunities.
In general the passive activity limitation rules prevent taxpayers from using losses from passive activities to offset income from active activities. Losses from unused passive activities can be carried forward to future tax years or deducted in full upon the taxable disposition of the loss asset.
Active activities include income from a trade or business, wages, and interest and dividends. Passive activities include trade and businesses in which the taxpayer does not materially participate and rental real estate activities. The passive activity rules do not apply to rental activities performed by a real estate professional and certain short term rental activities.
With this said, there is an exception that allows a taxpayer to use up to $25,000 of passive rental real estate losses to offset active income. To qualify for this $25,000 exception the taxpayer must be an active participant, which is different than the more stringent "material participant" requirement (discussed below), and the taxpayer must have recognized less than $100,000 from all sources during the year (technically it is $100,000 of Adjusted Gross Income (AGI), which is income less certain above the line deductions, less certain types of income). The $25,000 exception is phased out for taxpayers whose AGI is over the $100,000 threshold and it is completely phased out when AGI reaches $150,000.
To be an active participant one only has to participate in the activities associated with the property, such as making management decisions, approving new tenants, approving repairs or writing checks. For most weekend or small real estate investors this exception will allow them to use all of their passive real estate losses to offset some of their active income. If the taxpayer's AGI is over this amount, then their passive losses from rental real estate activities may be limited if they do not "materially participate" in the rental activity.
Taxpayers are deemed to have materially participated in a real estate activity if:
Participation in an activity includes almost any activity, including the taxpayers spouses efforts. It does not include efforts that the taxpayer expends as an investor or a limited partner in the activity.
Taxpayers have structured their real estate investments in a number of different ways to achieve their desired tax results, especially where real estate investments that are intended to be held for rental purposes are expected to generate losses in excess of $25,000 for many years and/or the taxpayer's AGI is too much to qualify for the $25,000 exception to the passive activity rules.
The trick to understanding and planning for these rules is determining whether the taxpayer has or expects to have other passive income or losses. If the taxpayer has other passive income and a passive loss from the rental investment, the taxpayer may want the passive loss from the rental activities to remain passive. That way the taxpayer can use the rental loss to offset the other passive income. On the other hand, if the taxpayer has only passive losses the taxpayer may want to consider other alternatives for their rental real estate losses.
This is where transferring ownership of the rental property to a Subchapter S corporation and entering into a lease back arrangement might be helpful. S corporations are flow through entities and they are not subject to the passive activity rules; however, the owners of the S corporation is individually subject to the passive activity rules. The S corporation is simply a legal entity, such as a regular C corporation or Limited Liability Company, for which the taxpayer has made a S corporation election with the IRS.
Generally contributing rental real estate to a S corporation results in no negative tax consequences. The taxpayer takes a tax basis in the S corporation stock equal to the amount of the rental property contributed (less certain deductions) to the S corporation and the S corporation takes a tax basis in the rental real estate equal to the taxpayers basis in the S corporation stock.
If the S corporation owns the rental real estate and the S corporation rents or leases the property back to the S corporation owner, any loss from the rental activity will be deemed to be a passive loss if the owner materially participated in the S corporation business (this is often referred to as the "self-rental rule").
So why would a taxpayer enter into this type of transaction? The answer is that if the S corporation is expected to generate other losses, those losses will flow through to the taxpayer and can be used to offset the taxpayer's other active income. If the taxpayer did not enter into this type of transaction these other S corporation losses may not have been recognized until sometime in the future, as S corporation losses can only be deducted to the extent of the taxpayer's tax basis in the S corporation - which the contribution of the rental property to the corporation increased.
Given the current speculation that there is a "real estate bubble" that is about to "burst," it is important that current rental real estate investors understand these rules and consider whether they can benefit from restructuring their rental real estate holdings.
In general the passive activity limitation rules prevent taxpayers from using losses from passive activities to offset income from active activities. Losses from unused passive activities can be carried forward to future tax years or deducted in full upon the taxable disposition of the loss asset.
Active activities include income from a trade or business, wages, and interest and dividends. Passive activities include trade and businesses in which the taxpayer does not materially participate and rental real estate activities. The passive activity rules do not apply to rental activities performed by a real estate professional and certain short term rental activities.
With this said, there is an exception that allows a taxpayer to use up to $25,000 of passive rental real estate losses to offset active income. To qualify for this $25,000 exception the taxpayer must be an active participant, which is different than the more stringent "material participant" requirement (discussed below), and the taxpayer must have recognized less than $100,000 from all sources during the year (technically it is $100,000 of Adjusted Gross Income (AGI), which is income less certain above the line deductions, less certain types of income). The $25,000 exception is phased out for taxpayers whose AGI is over the $100,000 threshold and it is completely phased out when AGI reaches $150,000.
To be an active participant one only has to participate in the activities associated with the property, such as making management decisions, approving new tenants, approving repairs or writing checks. For most weekend or small real estate investors this exception will allow them to use all of their passive real estate losses to offset some of their active income. If the taxpayer's AGI is over this amount, then their passive losses from rental real estate activities may be limited if they do not "materially participate" in the rental activity.
Taxpayers are deemed to have materially participated in a real estate activity if:
- They participated in the activity for more than 500 hours during the year,
- Their participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
- They participated in the activity for more than 100 hours during the tax year, and they participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
- The activity is a significant participation activity, and they participated in all significant participation activities for more than 500 hours (A significant participation activity is any trade or business activity in which a taxpayer participated for more than 100 hours during the year and in which they did not materially participate under any of the material participation tests, other than this test).
- They materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which they materially participated for any 3 (whether or not consecutive) preceding tax years (An activity is a personal service activity if it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor).
- Based on all the facts and circumstances, they participated in the activity on a regular, continuous, and substantial basis during the year.
Participation in an activity includes almost any activity, including the taxpayers spouses efforts. It does not include efforts that the taxpayer expends as an investor or a limited partner in the activity.
Taxpayers have structured their real estate investments in a number of different ways to achieve their desired tax results, especially where real estate investments that are intended to be held for rental purposes are expected to generate losses in excess of $25,000 for many years and/or the taxpayer's AGI is too much to qualify for the $25,000 exception to the passive activity rules.
The trick to understanding and planning for these rules is determining whether the taxpayer has or expects to have other passive income or losses. If the taxpayer has other passive income and a passive loss from the rental investment, the taxpayer may want the passive loss from the rental activities to remain passive. That way the taxpayer can use the rental loss to offset the other passive income. On the other hand, if the taxpayer has only passive losses the taxpayer may want to consider other alternatives for their rental real estate losses.
This is where transferring ownership of the rental property to a Subchapter S corporation and entering into a lease back arrangement might be helpful. S corporations are flow through entities and they are not subject to the passive activity rules; however, the owners of the S corporation is individually subject to the passive activity rules. The S corporation is simply a legal entity, such as a regular C corporation or Limited Liability Company, for which the taxpayer has made a S corporation election with the IRS.
Generally contributing rental real estate to a S corporation results in no negative tax consequences. The taxpayer takes a tax basis in the S corporation stock equal to the amount of the rental property contributed (less certain deductions) to the S corporation and the S corporation takes a tax basis in the rental real estate equal to the taxpayers basis in the S corporation stock.
If the S corporation owns the rental real estate and the S corporation rents or leases the property back to the S corporation owner, any loss from the rental activity will be deemed to be a passive loss if the owner materially participated in the S corporation business (this is often referred to as the "self-rental rule").
So why would a taxpayer enter into this type of transaction? The answer is that if the S corporation is expected to generate other losses, those losses will flow through to the taxpayer and can be used to offset the taxpayer's other active income. If the taxpayer did not enter into this type of transaction these other S corporation losses may not have been recognized until sometime in the future, as S corporation losses can only be deducted to the extent of the taxpayer's tax basis in the S corporation - which the contribution of the rental property to the corporation increased.
Given the current speculation that there is a "real estate bubble" that is about to "burst," it is important that current rental real estate investors understand these rules and consider whether they can benefit from restructuring their rental real estate holdings.
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