How to navigate the Passive Loss Labyrinth rules handed down to us by the IRS, continued

Real Estate Professionals and Material Participation. First of IV parts.

By Gary Krupa, CPA.
May 22, 2021.

Updated:

May 23, 2021.
September 5, 2021.

My mission parameters:

1) to make the tax laws easier for you to understand,
2) explain how to use the tax laws to your advantage and
3) to help you save money and avoid financial stress.

Why you should read this article if you own rental real estate

This article will help you deduct your passive rental loss or losses in full for the current year. If you don’t take the steps outlined below, you won’t be able to deduct them in the year you incur the passive loss unless you also have passive income. This can result in your having to pay thousands of dollars more than you expected to pay when you file your tax returns.

The Passive Loss Rules Labyrinth

How I made studying this complex topic easier

This is a jargon-free, simplified version of a 19-page article featured on The Tax Adviser. The title of that article is Navigating the Real Estate Professional Rules. The The Tax Adviser article also includes IRS code sections, case law, a case study and other references.

This blog article, in contrast, is six to seven pages long. It features much shorter sentences. I’ve taken great pains to make sure that it’s well-organized and filled with relevant information. Thus you should find it easy to understand. In fact I made that my “prime directive”. It should therefore take you no more than an hour to read. Reading the The Tax Adviser article should take you at least two or three hours unless you’re a tax accountant or tax lawyer. Then you should be able to read it in an hour or two.

However, some may still find this article overwhelming to read all at once. That’s why I’ve revised it so it’s divided into four parts. That way, you can read it at your leisure and still fully grasp its meaning.

One of my aims is to interpret for you, the reader, the more technical terms in that article, such as the material participation rules. Use this as a handy reference guide. It may be all you need. If you’re seeking a more in-depth treatment of this subject, I suggest reading the article in The Tax Adviser. Or, you can study the intricacies of Passive Loss taxation in a Continuing Professional Education course like the one I’ve been taking called Real Estate Tax Planning.*  The chapter on the Passive Loss rules in that course is about as comprehensive as any article I’ve read, perhaps more so.

A recap of the Passive Loss Rules

A. You may not deduct losses from a passive activity in the year you incur the losses. You can, however, if you have income from a passive activity to offset them. Otherwise you must carry the losses forward to a year that you have passive income.

B. The IRS will consider your activity passive if you don’t “materially” participate in it.

C. Rental activities are passive by default.

D. If you (a) qualify as a “Real Estate Professional”, and (b) materially participate in the activity, your rental activity is no longer passive. It’s active.

You don’t have to be in the real estate business to qualify as a Real Estate Professional for tax purposes. But then, if you’re a Real Estate Broker or a landlord you’re in the right businesses to qualify as one. Qualifying just means you’re one big step closer to deducting your real property losses in full.

As a Real Estate Professional, you also won’t have to pay the 3.8% Net Investment Income Tax on Passive Activity Income. However you must derive the income in the ordinary course of your trade or business.

Congress added the exception for Real Estate Professionals in 1993. It allows you to offset losses from rental properties against income from sales of property in the same year. Without that rule, you could only carry the losses forward while having to pay tax on the income currently.

You’ll find these rules stated in Internal Revenue Code Section 469.

Next, in Part II: What you’ll need to do to qualify as a Real Estate Professional

* Written by Danny Santuccci, J.D., published by Beacon Hill Financial Educators, 3/20/2020, chapter 6 “Passive Loss & At-Risk Rules”.