Owning rental real estate is a great source of income, but it can come with some considerations when figuring out how to treat the income from rental property once tax season rolls around. For tax purposes, the key is determining if your level of involvement with your real estate qualifies as active or material participation in real estate.
Real estate is generally perceived as a passive investment, which generates passive income for tax purposes. However, depending on how involved you are in the property or if you are a professional in real estate, you may be able to treat the income from real estate as active income for tax purposes.
Why does this classification matter? If you are considered materially involved then you can deduct losses the real estate generates from ordinary income. If the rental real estate generates income, then you may be able to avoid the net investment income tax. There are certain criteria that will determine whether or not you qualify as actively or materially involved.
What is Passive Income?
Passive activity involves a business or trade where the taxpayer doesn’t materially participate. Therefore, passive income is generated from an investment such as rental property or a business where the taxpayer doesn’t materially participate.
Rental real estate is generally considered a passive activity, so passive real estate losses are typically only deductible against passive activity income.
Easily Save Clients Thousands in Taxes
Scan client returns. Uncover savings. Export a professional tax plan. All in minutes.
What is a Suspended Passive Loss?
According to the IRS, there is a limit on capital loss deductions. If capital losses are greater than capital gains, the passive real estate loss has a limit of $3,000 per year.
Due to passive activity limitations the capital loss cannot always be realized during a given tax year and becomes a suspended passive loss. This means the loss is “suspended” until it can be carried forward and claimed in a fiscal year when you have more passive income or when the investment is sold.
This can be done in one of two ways: (1) if there is any net operating loss left over after going back two years, you can carry the balance forward to offset any future income for up to 20 years or (2) you can choose not to go back two years and carry it forward 20 years.
What is the Exception to the Passive Activity Loss Rules?
Professionals in real estate are considered exceptions to passive activity loss rules. For professionals, rental real estate activity losses are deductible against nonpassive income, such as Schedule C income or wages.
What Are The Criteria For Qualifying as a Real Estate Professional?
There are two criteria that must be met to be considered a real estate professional.
How Much Material Participation is Required?
During the taxable year, a taxpayer must perform over 50% of their personal services in businesses or real property trades where the taxpayer materially participates. Material participation is considered consistent and significant participation in the activity.
How Many Real Estate Personal Service Hours Are Required?
This same taxpayer must perform more than 750 hours of service in a given tax year in real property trades or businesses where there is material participation. Personal service hours are considered time spent managing the everyday operations of the rental.
To qualify as a real estate professional, both of these criteria must be met by the same taxpayer. With those married filing jointly, one spouse must meet both criteria themselves. These criteria can not be a joint effort.
What is Not Considered a Rental Activity?
There is an exception to what is considered rental activity. If the average use for the property by a customer is seven days or less it is not considered rental activity.
Therefore, most VRBO and AirBnB are not considered rental activities. You also don’t need to qualify as a real estate professional to claim losses from a rental activity that is short-term as non-passive. All you need to do is demonstrate that you materially participated in the short-term rental and your losses will be considered non-passive.
If you don’t qualify as a real estate professional, taxpayers who work full-time or have a business role, can still invest in short-term rentals and deduct rental losses as non-passive.
What are the Requirements for Material Participation?
In order to have materially participated, you have to meet one of the seven following criteria:
- You spend 500 or more hours working with your rental real estate;
- You do the vast majority or all of the work when it comes to your rentals;
- You work over 100 hours at the rental property during the given tax year and no one else works any more than this;
- The rentals are classified as a significant participation activity and the SPA exceeds 500 hours for the year;
- You materially participated in the rentals in any 5 out of the 10 previous years;
- The rentals are a personal service activity and you materially participated in any 3three prior years;
- If you work 100 hours with the rentals, no one works any more than that, no one else is compensated for managing the real estate property, and you work consistently and significantly on the property throughout the year.
The long-term rental of real estate is a passive activity even if you participate materially. You are exempted from this if you’re a real estate professional.
What is Considered Material Participation in Real Estate?
For tax purposes, there is a distinction between different income types. This includes passive investment income and active business income where the taxpayer materially participates. Material participation determines whether or not and to what extent you can deduct losses on your taxes. You can claim material participation if you were a consistent and significant participant. This means you were involved in the operations of the activity on a regular, continuous, and substantial basis.
If you did not materially participate in your business activity, then the rental real estate is considered a passive activity. The losses you can deduct are limited since passive losses can only be deducted from passive income.
What is Active Participation in Real Estate?
You can be eligible as an active participant in real estate if you own 10% or more of the rental property, have significant involvement in the management of the rental property, and are not a limited partner.
With active participation in real estate, you may be eligible to deduct up to $25,000 from your rental real estate in passive losses each year from non-passive income. When the AGI is over $100,000, the allowance is cut in half and when the AGI rises to $150,000, the allowance goes to zero.
What is Net Investment Income Tax?
Net investment income are gains received from investment assets, such as rental property, before taxes. The tax rate depends on the type of income. Net investment income is subject to a 3.8% tax and applies to taxpayers with net investment income and modified adjusted gross income above certain thresholds.
Real estate professionals can waive the net investment income tax if the rental activity rises to a trade or a business and material participation takes place in the business.
Getting the Most Out of Real Estate Tax Strategies
If you own rental real estate and are looking for ways to save on your taxes, tax deductions and credits can be a powerful strategy. However, good rental real estate owners use a variety of tax strategies each year. Tools such as Corvee tax planning software help taxpayers quickly find the strategies available to them. Corvee has many more tax credits and deductions for real estate. Learn more about tax strategies and request a demo today to get started.
