Rental activities are consider passive activities by definition and rental activities are subject to the rule affecting passive activities and the limitations for losses coming from such activities. The taxpayer’s level of participation in their rental activities involving real estate can have an impact on the treatment that any income and/or losses will receive on the tax return. The three levels of participation are Active, Material, and Real Estate Professional.
Active Participation
A taxpayer is considered to actively participated in a rental real estate activity if the taxpayer, and the taxpayer’s spouse if filing joint, owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.
Material Participation
A trade or business activity is not a passive activity if you materially participated in the activity. Material Participation is defined as the taxpayer being involved in the activity on a basis that is “regular, continuous, and substantial”. The IRS has a series of test to indicate if you materially participated or not:
- The individual worked in the activity for more than 500 or more hours during the year,
- The individual’s participation in the activity constitutes substantially all of the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own interest in the activity,
- The individual participated in the activity for more than 100 hours during the tax year, and the individual’s participation was at least as much as any other individual for the year,
- The activity is a ‘significant participation activity’ for the year (more than 100 hours participation per activity with aggregate of 500 hours),
- The individual materially participated in the activity for any five (whether or not consecutive) of the ten immediately preceding tax years,
- The activity is a personal service activity and the individual materially participated in the activity for any three preceding tax years, or
- Based on all the facts and circumstances, the individual participated in the activity on a regular, continuous, and substantial basis during the year. This test is not met if the individual participated in the activity for 100 hours or less during the year. Managing the activity does not count for this purpose if any person other than the individual received compensation for managing the activity, or an individual spent more hours during the year managing the activity.
Real Estate Professional
Activities of real estate professionals are not treated as passive activities. The taxpayer qualifies as a real estate professional if both of the following conditions are met:
- More than half of the personal services the taxpayer performed in all trades or businesses during the year were performed in real property trades or businesses in which the taxpayer materially participated, and
- The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participated.
Real property trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services you performed as an employee are not treated as performed in a real property trade or business unless you owned more than 5% of the stock (or more than 5% of the capital or profits interest) in the employer. If you are married filing jointly, either you or your spouse must meet both of the above conditions, without taking into account services performed by the other spouse.
For purposes of qualifying as a real estate professional, each of the taxpayer’s rental activities are treated as separate activities unless the taxpayer elects to treat all interests in rental real estate as a single activity. This election is made pursuant to 26 CFR §1.469-9(g). Failure to make this election can trigger passive loss limits for real estate professionals.
To make the election in Keystone Tax Solutions Pro, the taxpayer must file a statement with the original income tax declaring that he or she is a qualified taxpayer for the taxable year and is making the election to treat all interest in rental real estate as a single rental real estate activity pursuant to IRC section 469(c)(7)(A). The election is binding for the taxable year it is made and for all future years whether or not the taxpayer continues to be a qualifying taxpayer. To produce the election statement, from the Main Menu of the Tax Return (Form 1040) select:
- Income
- Schedule E
- IRC Section 469(c)(7)(A) Election – answer YES to make the election
The election can be revoked in the year in which the taxpayer’s facts and circumstances have materially changed from the taxable year in which the election was made. To revoke the election, from the Main Menu of the Tax Return (Form 1040) select:
- Miscellaneous Forms
- Notes/Statements
- Elections Explanations (sent to the IRS)
- Select New and create a statement indicating that the election under Section 469(c)(7)(A) is being revoked and explain the nature of the change in facts and circumstances.
Exception for Certain Rental Real Estate Activities – Special $25,000 Allowance for Rental Losses
If a Taxpayer actively participates in a rental activity that has a loss, the Taxpayer may be able to deduct up to $25,000 of the loss against their Non Passive Income ($12,500 if Married Filing Separately).
When the Taxpayer’s modified adjusted gross income is $100,000 or less ($50,000 or less if Married Filing Separately), the loss is deductible up to a maximum special allowance of $25,000.
If the Taxpayer’s modified adjusted gross income is more than $100,000 ($50,000 if Married Filing Separately) but less than $150,000 ($75,000 if Married Filing Separately), the special allowance is limited to 50% of the difference between $150,000 ($75,000 if Married Filing Separately) and the Taxpayer’s modified adjusted gross income. This special allowance is calculated on Form 8582.
It is not available to any individuals whose filing status is Married Filing Separate unless the individuals lived apart for all of the year.
NOTE: This is a guide on Real Estate Real Estate Participation being Active or Material and entering it in the Keystone Tax Solutions Pro program. This is not intended as tax advice.
Additional Resources:
Publication 527, Residential Rental Property
Publication 925 – Passive Activity & At-Risk Rules
Instructions for Form 8582 – Passive Activity Loss Limitations