Managing the Net Investment Income Tax and Passive Loss Limitations for Real Estate Activities

Historically, the classification of individuals as real estate professionals had everything to do with the utilization of losses generated from the related trade or business. Thanks to The Heath Care and Education Reconciliation Act of 2010, the generation of net rental income now receives just as much scrutiny. Since 2013, an additional 3.8 percent tax has been assessed on various types of investment income, including passive activities.

Passive activities that generate net investment income include, notably, real estate rental activities. As with most items relating to the Internal Revenue Code, there is an exception: Real estate rental activities of materially participating real estate professionals.

Say you own real estate with the intention of making a profit. That would make you a real estate professional who is entitled to deduct losses when generated and is exempt from the additional 3.8 percent tax, correct? Not so fast. The IRS has tests to determine whether you qualify as a materially participating real estate professional.

In order to properly evaluate whether someone qualifies as a materially participating real estate professional in the eyes of the IRS, it is important to understand the pieces that make up this puzzle:

Challenge No. 1 – Qualifying as a Real Estate Professional

  • More than half of personal services must be in real property trades or businesses. This means that an individual must spend more hours on real estate activities than any other job to prove a living is earned in the real estate industry.
  • More than 750 hours must be spent in a real property trade or business in which an individual materially participates.

Challenge No. 2 – Material Participation

To establish whether an individual materially participates in a real property trade or business, any one of seven tests put forth by the IRS needs to be satisfied. Note: See end of article for more detail about these seven tests.

It is worth mentioning that often the most difficult, yet important, task relating to classification as a real estate professional is documenting and supporting material participation in real estate activity. This is important not only to preserve your ability to recognize losses from the activity, but also to limit your net investment income tax liability.

Grouping

It is not uncommon for individuals who qualify as real estate professionals in the eyes of the IRS to hold interests in more than one real estate activity. The tests presented above could be difficult to pass if more than one activity is being conducted. The material participation test is determined separately with respect to each rental property, unless a decision is made to treat all interests in rental real estate as a single rental real estate activity.

Determining the tax implications relating to activities of rental real estate has never been easy, and the introduction of the 3.8 percent additional tax makes it even more challenging.

 

IRS Material Participation Tests

  1. More Than 500 Hours Test: The taxpayer participates in the activity for more than 500 hours during the year.
  2. Substantially All Participation Test: The taxpayer’s participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year.
  3. More Than 100 Hours Test: The taxpayer’s participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than the taxpayer.
  4. Significant Participation Activity (SPA) Test: The activity is a significant participation activity in which the taxpayer participates for more than 100 hours during the year and the taxpayer’s annual participation in all significant participation activities is more than 500 hours.
  5. Prior-Year Material Participation Test: The taxpayer materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years.
  6. Personal Service Activity Test: For a personal service activity, the taxpayer materially participated for any three tax years (whether or not consecutive) preceding the current tax year.
  7. Facts and Circumstance Test: Based on all the facts and circumstances, the taxpayer participates on a regular, continuous, and substantial basis during the year.

Kreischer Miller’s Tax Strategies group can provide practical advice for determining how the rules for a real estate professional apply to your specific situation.

Lisa G. Pileggi can be reached at Email or 215.441.4600.

 

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