The IRS’s Dirty Little Trick on Real Estate Investors – Material Participation Rules


This post is in: Real Estate
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08-18-2010-1

You might have heard about the benefit of real estate paper losses. In other words, you’ve got cash flow you put in your pocket, but it’s not only completely tax free, you’ve also got losses you can use to offset your other income.

So it’s tax-free cash flow and even less taxes than you normally pay. Fantastic! Who wouldn’t love it!

But the problem is that if you make too much income (over $150,000) you can’t take any of the real estate losses against your other income.

The loophole is something called “real estate professional” status. That means that you are involved in real estate activities (as defined in the IRS guidelines) for more hours in a year then you spend in any other trade or business and you have a minimum of 750 hours per year in that activity.

A lot of people learned about this trick and jumped on the bandwagon with varying levels of success, because they didn’t always follow the rules closely.

Even worse, they didn’t know about the 2nd part of the test. It’s called material participation.

Besides spending time in real estate activities, you need to also materially participate to the tune of 500 hours per year per property. You can make an election to aggregate the properties which then lets you meet only one 500 hour requirement. The election needs to be made on your tax return.

There is one caveat, though. If you sell one of the properties in an aggregated group, the group ‘captures’ the loss until all the properties sell. So you don’t get immediate benefit of the loss. There is a way out, though, you need to de-aggregate before hand.

That’s how material participation works. Here are some ways you might get in trouble with it:

  • Not making an aggregation properly and flunking the 500 hours per property requirement.
  • Holding your property in a Limited Partnership of which you are a Limited Partner
  • Holding your property in a manager-managed LLC of which you are not a manager

Get the right advice before you take the deduction!



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