Rental real estate acquisitions: tax implications

Your Guide to State, Local, Federal, Estate + International Taxation

real estate, rental property, taxI was having a telephone conversation with a friend of mine a couple of weeks ago which nearly always turns into thirty minutes of free tax advice based upon what he has going on in his life. After a few minutes of asking about family, work, and the status of our golf game, this conversation was no different. He had just purchased real estate – a rental residence – and had planned (based on what he had heard from his friend) to receive a current year tax benefit from all the improvement and operating costs he incurred during the year. Not so fast I said.

The passive activity loss rules generally apply to all rental activities regardless of whether a taxpayer materially participates. In 1993, Congress amended the passive activity loss statute to provide an exception for real estate professionals. The tax code defines a real estate professional as a taxpayer who materially participates in real property trades or business for more than 750 hours, and performs more than one-half of their personal services during the year in real property trades or businesses. If these criteria are met during the year, the rental property will not be subject to the general rule that all rental activities are treated as passive.

My friend is a full time dentist and he owns one rental property. He is looking for current tax deductions to offset his income from his work as a dentist – because that is what his friend told him – remember? The passive activity rules limit the amount that certain taxpayers may deduct or claim as a credit from a passive activity. A taxpayer is allowed to deduct passive activity losses only to the extent of the taxpayer’s passive activity income arising from all passive activities. (In my example, no other passive income activities exist). Therefore, these losses must be carried over and will be allowed only in a year in which other passive income exists, or the property is disposed of in a fully taxable transaction.

The 750 hour material participation rule needs to be substantiated, and the burden of proof is on you. The individual’s participation in an activity may be established by any reasonable means. You must maintain detailed, accurate and contemporaneous records. Do not “guesstimate” time spent for substantiation purposes.

So, now you have heard the bad news – what is the potential good news? The tax code permits certain eligible taxpayers who actively participate in a rental real estate to deduct up to $25,000 of losses from the rental real estate activity, if the taxpayer cannot meet the material participation test. Under the tax code, an individual will not be considered to actively participate in any real estate activity if the taxpayer owns less than a 10% interest in the activity at any time during the year. The active participation requirement is a much less stringent test than the material participation test and an example of participation includes making management decisions, approving tenants, and approving capital expenditures. There is no specific hour requirement. The $25,000 of allowable losses is subject to modified adjusted gross income (MAGI) phase-out limits and these rules should be reviewed to determine if any current year tax benefit from your rental can be utilized.

Surprisingly, we are still friends – even after I discussed several of the items mentioned above. It was not the answer he expected based on what he had heard. Always consult a tax professional before making assumptions on what is deductible for tax purposes. There are always exceptions to deductibility based on differing fact patterns. However, oftentimes perception and reality are quite different in the world of taxation.

Ryan D. Gorman, CPA