For the past 8 years, the IRS has been cracking down on investors who attempt to use their passive real estate investment losses to offset other income.
IRC §467 limits an investor’s ability to use passive losses to offset their ordinary or earned income. As a general rule, passive losses may be used only to offset passive income, and rental activities are generally considered passive under this code section. Taxpayers who “actively participate” in their rentals (e.g., select or approve tenants, negotiate leases, manage property repairs and capital improvements) are entitled to a maximum $25,000 offset under IRC §467(i). Note that per IRC §467(i)(3), the $25,000 loss will be reduced by 50% if the taxpayer's adjusted gross income exceeds $100,000.
Special passive loss rules for real estate professionals
IRC §467(c)(7) provides special rules regarding real estate investment losses for real estate professionals. For taxpayers who qualify, all losses connected with their real estate investments may be applied without limitation. It is no wonder that so many taxpayers with real estate interests try to fit themselves into this classification!
What is a Real Estate Professional?
IRC Sec. 469(c)(7)(C) defines a real estate professional as someone who spends the majority of their time in one or more of the following real estate trades or businesses:
- Real property development or redevelopment
- Construction or reconstruction
- Rental or leasing
- Operation or management
- Brokerage trade or business
Being in the business isn’t enough. Under IRC Sec. 469(c)(7)(B), to receive an unlimited real estate investment deduction, a taxpayer must also demonstrate that more than 50% of their activities, and more than 750 hours of their time, during the taxable year at issue was spent “materially participating” in a real property trade or business.
"Material participation" - a higher standard
The “material participation” standard that allows all real estate investment losses to be deducted is a much stricter standard than the “active participation” requirement for a $25,000 offset under IRC §467(i). In Part II, we will review the time tests, the requirements of “material participation” and provide some tips on how to increase the likelihood of your deductions surviving an audit.
Skilled and aggressive tax audit representation
In the area of real estate loss deductions, IRS auditors tend to cast an exceptionally wide net. If you are a real estate investor whose deductions have been disallowed and/or you are being audited, you need a highly skilled and aggressive tax attorney on your side. The tax lawyers at Moskowitz, LLP have vast experience representing thousands of clients before the IRS and state taxing agencies. We welcome your call.
Also see: Part II