The hottest tax topic is still the real estate professional tax deduction versus the IRS. Let’s start off with what that is and why it’s important.
You may have heard that the three benefits of real estate investing over any other type of investing are:
- Cash flow,
- Possibility of appreciation, and
- Tax breaks.
Unfortunately, if you buy too high or in a market with high prices and relatively lower rents, you won’t have positive cash flow. This was especially true in some of the really overheated markets like southern California in the pre-2007 crash years. So, cash flow wasn’t a viable option for a lot of people. Some people still have that issue with their real estate.
Hopefully, your property will appreciate. That’s true for any asset you purchase. So, real estate isn’t really different from any other asset in that regard.
The promised tax breaks come about because you thought you could offset real estate losses against other income. In fact, there were a lot of famous real estate seminar promoters who told you could. And, you can. But only in the right circumstances.
If you have a real estate loss, you can take that up to $25,000 of loss against other income provided your adjusted gross income (AGI) is less than $100,000. If your income is over $150,000, you can’t take any of the loss. The amount allowed for deduction phases out when your income is between $100,000 – $150,000.
There is an exception and this is where the controversy with the IRS comes in. If you are a qualified real estate professional, you can take an unlimited amount of real estate losses, no matter how much other income you have.
There are three tests to take a qualified real estate professional deduction. Please note: There are THREE tests. It doesn’t matter if you read something that was 10 years old and only talked about one of the tests. Today, here and now, you must pass 3 tests.
#1: You or your spouse (if you file married filing jointly) must qualify as a real estate professional. That means you spend at least 750 hours per year performing real estate activities. If you have another job or business, you must spend more time in real estate activities.
Recently I saw a mistake that someone had made by thinking all they needed to do to be a real estate professional in the eyes of the IRS was get a real estate license. They didn’t think the other two tests were important or even realize that just getting a license will do it. You can only pass this test if you spend at least 750 hours per year and have more hours doing this than any other job or business.
Remember that these hours are either you or your spouse. You can’t combine the hours.
#2: You must have material participation for your property. There is so much confusion about what this means. It is not active participation. It’s material participation with a very specific definition in the IRS code. Some of the things that would qualify are:
- You and your spouse (yes, you can combine hours) have 500 hours of material participation in the property,
- You and your spouse have at least 100 hours and more than anyone else,
- You had substantially all of the hours spent working on this property (including non-owners), and
- Four other possibilities.
You must keep records of the hours you spent on the property. The IRS will assume you don’t participate if you have a property manager, so be prepared to prove you were involved and in what way.
#3: Each property must qualify by itself. They each have to qualify unless you make an election to aggregate the properties. If you make that election, you only have to meet the test once. There is a possible problem, though. If you sell one of the aggregated properties at a loss, you can not take that loss against other income.
The Real Estate Professional tax deduction is a tough one to prove if you try to skip the steps or gloss over the details. You need to have an experienced tax pro alongside you.