Do You Qualify for the Real Estate Professionals Exception to the Passive Activity Loss Rules?

By: Tyler B. Korn, Esq.

In general, a real estate rental activity is treated as a passive activity under Section 469(c)(2) of the Internal Revenue Code, regardless of the extent to which you materially participate in that activity. This rule of the tax code often poses significant tax difficulties for investors because losses from passive activities may not be deducted from non-passive income (such as wages, interest, or dividends).

However, certain real estate professionals may be able to treat rental real estate activities as non-passive. There are two requirements that must be met in order to qualify. First, more than one-half of the person services performed by you in trades or businesses during the tax year must involve real property trades or businesses in which you (or your spouse) materially participate. Second, you must perform more than 750 hours of service during the tax year in real property trades or businesses in which you (or your spouse) materially participate.

These rules are applied as if each of your interests in rental real estate were a separate activity, although qualifying taxpayers can elect (by filing a specified statement) to treat all interests in rental real estate as one activity.

It should be noted that personal services performed as an employee are not taken into account for purposes of the two-part test unless you own more than a 5 percent interest in the employer. Closely-held corporations can qualify as real estate professionals if more than 50 percent of their annual gross receipts for the tax year are derived from real property trades or businesses in which they materially participate.

Qualifying taxpayers who materially participate in a rental real estate activity may avoid automatic passive activity characterization, and accordingly can use losses or credits generated by the activity to offset non-passive income.

Other important exceptions and rules do apply to passive activities. If you believe that some of your income or loss might be tainted by “passive activity,” it is important that you seek experienced counsel for analysis and planning specific to your situation.

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