You might have already heard that IRS audits are way way up for anyone showing a real estate loss. And they are scrutinizing the returns to make sure you’re in full compliance with the law.
No matter what your income level is or how much the loss is, there is one two word phrase you need to know. “Material Participation” You must have material participation to take a loss. Period.
Without material participation, your loss will be considered a passive loss and only used against passive income.
The rule for material participation is that you must have 500 or more hours per property per year. Yes, that’s PER property per year. If you have 10 properties, you’ll have to show 500 hours unless you aggregrate the properties.
And that has prompted a great conversation with Martin Wischhusen, a very experienced real estate investor and entrepreneur. We’ve been talking about the practicalities and tricks and traps of making this election.
Here are some highlights:
The time you spend on other real estate activities (for your real estate professional status) may not be applicable here. The material participation hours must be specific to activities on your real estate property. In other words, being a rental agent for other properties won’t count.
You can combine real estate property activities from fairly diverse properties, as long as they all would qualify for material participation. For example, if you own a time share, it’s not going to work to materially participate. The IRS specifically has not allowed time shares in this group. But you could include a commercial building in Denver, a single family residential rental in Topeka and an apartment house in Atlanta. This includes properties in which you have a partial interest.
You must make the aggregation election with the original return. There is a small window of 6 months in which you can go back and amend that return. But, miss that window, and you’re sunk.
If you add a property or dispose of a property, you need to make a new election.
If you have all of your properties aggregated and sell at a loss, that loss must be used against the remaining group. It is suspended until it can be used against a gain within the group or all the properties sell.
One of the issues that the IRS keeps coming up with is how active “active” is. They have been aggressively disallowing anything that smacks of management of another. For example, they haven’t allowed the hours spent checking in with a property manager, checking for properties online, or anything else that keeps you glued to your seat in your home office. They want you out and doing things. At this point, no Tax Court has taken on this new, more limiting definition by the IRS. So we don’t know if it will stick or not.
Do all this and you’ve got material participation. You can then take a loss of up to $25,000 against your other income provided you make less than $100,000. If you make more than $150,000 there is no deduction. Between $100K and $150K, the allowable loss is phased out.
You can take a deduction past that if you have real estate professional status. And that is a whole different set of rules!