Save Taxes By Taking the Real Estate Professional Loophole | USTaxAid

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Save Taxes By Taking the Real Estate Professional Loophole

Written by Diane Kennedy, CPA on July 9, 2022

There are three reasons why most people invest in real estate: cash flow, appreciation and tax benefits. And, a fourth benefit for some, you can buy real estate investments with leverage, using other peoples’ money.

The plan comes to a screeching halt for some, though, when they realize that they may not be able to take any of the real estate tax benefits.

How Does Real Estate Save on Taxes? 

The big tax break that comes with real estate is depreciation. It’s a phantom expense. Most deductions require you to spend money and, if you’re lucky, you get to take a deduction. But in the case of depreciation, you get to take the deduction without spending the cash.

Depreciation can be accelerated, slowed down, stopped and caught up. There are over 7 proven tax strategies with depreciation that can be used to create legal tax losses while you still put cash in your pocket.

This is where it gets complicated. For sure, you can create deductions to offset any real estate income you have, but can you also have a tax loss that will offset other income to greatly reduce your taxes?

Maybe.

If your adjusted gross income (AGI) is under $100,000 and you meet other requirements, you can take up to $25,000 in real estate losses against other income.

If your AGI is over $150,000, you can’t take any of the real estate losses against other income.

If your AGI is between $100,000 and $150,000, the amount you can deduct phases out. 

If Your AGI is Under $100,000 and You Have Real Estate Losses

This is applicable if you have passive real estate losses. Real estate business losses such as with fix-n-flip or short term rentals do not have the same restrictions.

You are allowed to deduct up to $25,000 in passive real estate losses against other income, as long as you:

  • You have sufficient basis,
  • You have active participation,
  • You must own at least 10% of the property, and
  • You cannot be a limited partner in a limited partnership. 

Basis means how much you personally have invested and at risk in the property. You need enough basis to cover losses you will take. 

For example, if you paid all cash for a $200,000 house, you will have $200,000 worth of basis in that property. If you paid $20,000 down and got a loan for $180,000, you may still have $200,000 in basis. It depends on whether the loan is in your name (adds to basis) or if you personally guaranteed it (adds to basis). In those cases, your basis is increased by debt for which you are responsible. If you haven’t signed for the debt, it doesn’t add to your basis.

You also need active participation in the real estate property. This is a different standard than material participation that we’ll talk about in a minute for the real estate professional status. According to the IRS, active participation includes approving new tenants, deciding on rental terms, approving expenditures and similar decisions. There is no minimum hourly amount required for active participation. 

You must own at least 10% of the property, even if you are adding a number of properties together to come up with $25,000 of loss 

You can’t be a limited partner. Limited partners can’t take losses on their real estate investments, except to offset income from limited partnership interest in other real estate investments.

Timeshares losses also do not count, no matter what.

When you are calculating the $25K total loss, you must first offset all qualifying property income for the year. If you have suspended losses that are carried forward, these can be used in that total, reducing the amount that is rolling forward.

The Real Estate Professional Loophole

If you qualify as a real estate professional, you can offset all of your passive real estate losses against your other income, no matter how much the loss is and no matter how much your AGI is.

But, you need to qualify.

There are three tests to qualify for the real estate professional status, in addition to the need for sufficient basis, a minimum ownership percentage and excluding limited partner status and time shares.

#1: You, or your spouse if you are filing as married, filing jointly, need to have 750 or more hours in real estate activities per year and more hours in real estate activities than any other trade or business.

Qualifying real estate activities include the following with real estate: 

  • Development
  • Construction
  • Acquisition
  • Conversion
  • Handling Rentals
  • Operating/Managing Property
  • Brokering Property

You must have 5% or more ownership of a business for which you work that does one of the above. In other words, you could work in construction full time, but if you don’t have 5% or more of ownership of the company, the hours don’t count. 

The real estate professional must acquire the hours by themselves. You can’t add together your hours with those of your spouse.

#2: You must have material participation. your material participation  hours hours can be combined with those of your spouse to meet the qualifying number. There are three ways that a real estate professional can have material participation:

  • Spending 500 hours or more per year, 
  • Spending 100 hours and more than any other person associated with the property, or
  • Spending more than all other persons associated with the property. 

Although this isn’t written in the Internal Revenue Code or follow-up Revenue Rulings or Procedures, the IRS has taken the position that if you have a property manager, the 500 hour+ is the only way to prove material participation. If you act as your own property manager, you can use any of the 3 methods.

#3: Each property must qualify. It is possible to make an election to aggregate properties so you only need to qualify once for the material participation hours.

There is a possible problem with aggregation, though. If you sell an aggerated property at a loss, the loss can only be used against other properties within the same group that are sold at a gain. It is not available to offset other income until after all other properties are sold. 

You can file to de-aggregate the properties, as long as you explain what has changed so that the properties are no longer similar and eligible to aggregate.

Obviously, there is planning and strategy required for making the real estate professional election.

But when you can use it correctly, you’ll save a whole lot in taxes.

Want to know more how to legally and safely use tax loopholes to reduce your taxes? Join our Wednesday Coaching class. The class is held on the 1st – 4th Wednesday at 5 pm Pacific. We cover topical business and real estate strategies to increase cash flow, build wealth, and of course, pay a whole lot less in taxes.

Join us today at Wednesday Coaching

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