Since the Great Recession of 2008, the nation’s rental market has been an economic bright spot for investors. The median rent for a new apartment climbed to $1,372 last year, a 26% increase from 2012. The 2008 housing crash led to stricter lending standards and thus to 37% of households renting their homes in 2014—the highest level in over 45 years. There are, however, caveats to owning rental property. One of the primary drawbacks of rental income is that Section 469 of the Code classifies all rental income as passive. This limits the amount of loss a taxpayer can claim on rental properties to the amount of passive income earned in the same tax year, with any excess loss carried forward to subsequent years or until disposition of the property. Another drawback to rental properties is a result of the Affordable Care Act. The Act reduced the potential appeal of owning rental property by imposing a 3.8% surtax on certain taxpayers’ passive rental income. Individuals will owe the tax if they have Net Investment Income and also have modified adjusted gross income over the following thresholds:
|MAGI Threshold Amount|
|Married filing jointly||$250,000|
|Married filing separately||$125,000|
|Head of household (with qualifying person)||$200,000|
|Qualifying widow(er) with dependent child||$250,000|
However, the IRS has carved out exceptions to this passive income treatment and created a “safe haven” from the surtax for “real estate professionals” that meet certain “material participation” requirements. To determine whether or not you meet this two part criteria, we must first determine who qualifies as a real estate professional. The IRS criteria is as follows:
- 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.
These two criteria are designed to a) prove you truly derive your income primarily through real estate and b) disqualify retirees who spend a few hours a week managing rentals. It should be noted however, that “real property trades or business” is defined by Sec. 469 (c)(7)(C) as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” Qualifying as a real estate professional is only the first step—the next step is to determine if you “materially participated” in the rental activities.
Material participation tests. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.
- You participated in the activity for more than 500 hours.
- Your 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.
- 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 did not own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you 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 (including veterinary services), 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, you participated in the activity on a regular, continuous, and substantial basis during the year.
You did not materially participate in the activity under test 7 if you participated in the activity for 100 hours or less during the year. Moreover, under this test your participation in managing the activity does not count in determining whether you materially participated if:
- Any person other than you received compensation for managing the activity, or
- Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).
If the real estate professional meets any one of the above criteria, not only can losses on a rental be counted against ordinary income, any profits from the rentals will be excluded from the Net Investment Income surtax of 3.8%. It should be noted that taxpayers qualifying as real estate investors are allowed to group rental properties and treat them as a single activity. In doing this, they can aggregate the hours they spend on multiple rental activities and avoid having to demonstrate that they materially participated in each property individually.
Although many rental property owners will find the “real estate professional” qualification impossible to meet due to other employment consuming more than 50% of their time, there is some relief for these individual tax payers. There is a less stringent standard of participation in rental activities known as “active participation”. Per the IRS, “ You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.” This qualification will allow you to deduct up to $25,000 of passive losses from your ordinary income. It will not, however, exempt your passive income from the 3.8% NIIT if you meet the income thresholds.
If you are seeking advice on how to avoid passes losses, call 214-696-1922 and ask for Mark Patten.
McKinnon Patten is a Texas CPA that provides accounting and advisory services to a full range of real estate entities and property types including residential, commercial and industrial.