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How to deduct unlimited real estate losses against other income while avoiding the pitfalls of tax laws.

By Stephen Moskowitz, J.D. LLM., Senior Partner and co-author Anthony Diosdi, J.D.., LLM., Senior Associate
Date Published: Dec 08 San Francisco Business Times

The Law Offices of Stephen Moskowitz, LLP has seen a major increase in audits and one of the common red flags we are seeing are taxpayers deducting real estate losses against ordinary income.

The Internal Revenue Code places constraints on netting real estate loss against income from other sources. As a general rule, a taxpayer cannot offset passive losses against wage, interest, or dividend income. The rental of real estate is generally a passive activity. However, Congress has promulgated special tax laws for passive losses associated with real estate rental income. Federal tax law provides that up to $25,000 of losses associated with real estate rental activities can be netted against ordinary income.

The key to claiming real estate losses from rental property is to qualify by actively participating in rental activity. Active participation standards are met if you own at least ten percent of the rental property and have substantial involvement in managing the rental (defined as you spending more than 500 hours at the activity and no one else spending more hours in that particular real estate activity than you). If you are a limited partner in the real estate rental activity, you will not qualify for the deduction. The $25,000 special loss allowance is phased out by fifty percent if your modified gross income exceeds $100,000. It reaches zero by the time your income hits $150,000.

The ideal scenario may be to take unlimited losses against ordinary income. For tax purposes, people who meet eligibility requirements are able to deduct against ordinary

income (wages, dividends, interest, etc) real estate losses in unlimited amounts, a departure from the general rules, which would prohibit this. To qualify for this unlimited tax deduction a taxpayer must meet the tax requirement known as being a “real estate professional.” For tax purpose, qualifying as a “real estate professional” means that either you or your spouse:

  • Must materially participate in the rental real estate activities.
  • More than fifty percent of your time spent working during a calendar materially participate.
  • Must s pend more than 750 hours of service during a calendar year performing real estate rental activities.

It is extremely important that you keep a timely log of all activities performed in real estate. The IRS will likely challenge logs prepared after the fact with “ballpark” estimates. Therefore, detailed logs are extremely important to substantiate your participation in the real estate rental market to the IRS in the event of an audit.

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