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Sidestep tax pitfall for passive activities

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in Small Business Tax,Small Business Tax Deduction Strategies

The tax law favors real estate investors who rise to “real estate professionals.” Generally, they aren’t limited by the passive activity rules for other investors.

Strategy: Elect to treat multiple activities as one real estate activity. This generally makes it easier to qualify as a real estate pro. However, as evidenced by a new court decision, favorable tax treatment isn’t automatic for real estate professionals.

Here’s the whole story: Generally, your annual write-off for passive activities is limited to your income from passive activities. In other words, you can’t claim an overall loss from passive activities.

A “passive activity” is one in which you do not “materially participate.” The IRS has established several tests for establishing material participation. For example, you’re a material participant if you spend more than 500 hours during the year on the activity. But rental real estate losses are available only to “active participants,” a more difficult test. And the write-off phases out if your modified adjusted gross income (MAGI) exceeds $100,000.

Conversely, there are no such limits for real estate professionals. Therefore, you can deduct a rental real estate loss against nonpassive income if:

  • More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
  • You spend more than 750 hours on your real property trades or businesses.
  • You materially participate in the rental real estate activity (all of your combined rental properties if you elect to combine them).  

In the new case, a couple was tripped up by the passive activity rules. They could not automatically claim losses from multiple real estate properties although one spouse qualified as a real estate professional. Reason: They didn’t meet the material participation test for each separate property. (Gragg,  DC-ND Calif. 12-CV-3813 YGR, 3/31/14)

Tip: To make the real estate professional election to combine rental properties, attach a statement to the 1040 for the tax year in question.

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