Passive activity loss rules are a set of rules generated by the U.S. Internal Revenue Service (IRS). They prohibit using losses from passive activity to offset earned or ordinary income. Passive activity loss rules forbid investors from using losses incurred from income-producing activities in which they are not materially involved, i.e. passive activity, to offset non-passive gains.
If the taxpayer is materially involved with activities that generate earned income, then the income is active income. Active income and may not be reduced by passive losses for income tax purposes. Generally, passive losses can only be used to offset or reduce passive income.
Ordinarily, the renting of real property is considered a passive activity, so any losses incurred in rental activity could be used only to offset income from passive activities. There is, however, an exception to this unfavorable passive activity loss rule for real estate professionals.
The main issue with passive activity loss rules is whether the taxpayer can demonstrate material participation in the passive activity. The IRS defines “material participation” as involvement in the operation of a trade or business on a “regular, continuous, and substantial basis.”
There are 7 specific tests for material participation. The one most commonly applied is that the taxpayer must work at least 500 hours in the business over the course of a year. If the taxpayer is materially involved in the activity that generates the income, then it is not passive income. And losses from the activity can be used to offset gain in the form of earned income.
The problem is that rental activity can never qualify to be viewed as an activity from which losses can be used to offset non-passive gains under the material participation test, unless the taxpayer, the participant in the activity, is a real estate professional.
What Is the Exception to Passive Activity Loss for Real Estate Professionals?
The leasing of real property is not considered a passive activity for a taxpayer who is a real estate professional. This means that losses generated by real estate rentals would not be limited to offsetting only income from passive activity. They can offset earned income from other activities as well if the taxpayer is a real estate professional.
Who Is a Real Estate Professional?
A taxpayer is considered a real estate professional if they satisfy the following criteria:
- More than one-half of the business services personally performed in a trade or businesses by the taxpayer during the tax year is done in connection with real property trades or businesses in which the taxpayer materially participates; and
- The taxpayer provides service for over 750 hours during the tax year in a real property trade or business in which the taxpayer materially participates.
What Is a Real Property Trade or Business?
The following activities are considered to constitute “real property trades or businesses” for IRS purposes:
Can I Be a Real Estate Professional If I Am an Employee Working in a Real Estate Company?
In order for their services to qualify as services performed in a real property trade or business, the employee of a real estate company who performs the services must have a 5% or greater ownership interest in their employer. So, basically this means that an employee must own part of the company for which they work in order to qualify as a real estate professional.
What Is Material Participation for Other Taxpayers Who Are Not Real Estate Professionals?
If the services of a taxpayer who is not a real estate professional rise to the level of material participation, then the income generated can be characterized as active income, i.e., non-passive income. In this case also, any losses incurred can be used to offset earned income from whatever source.
In order for the services of a taxpayer who is not a real estate professional to qualify as material participation, they must meet 1 of any of the following 7 criteria:
- Participation for Over 500 Hours: The taxpayer participated in the activity for over 500 hours during the tax year. Note that if the taxpayer is married and files a joint return, the hours their spouse spends participating in the business activity count toward the 500-hour requirement for material participation;
- Most of the Participation: The activities of the taxpayer constitute substantially all of the participation in the business, trade, or income-producing activity. In other words, the taxpayer did most of the work involved in operating the trade, business or other income-producing activity;
- The Maximum Participation Is Over 100 Hours: The participation of the taxpayer in the activities during the tax year amounted to more than 100 hours and the taxpayer did not perform fewer hours than any other person who also participated in the activity. Rental activities cannot use this standard;
- Five Hundred Hours of Significant Activity: Participation in the activity is significant, and the total value of all the significant participation exceeds 500 hours. This is known as a significant participation activity;
- Five Out Of Ten Tax Years: The taxpayer has participated materially in the activity for any five of the 10 tax years before the current tax year;
- Three Years Before the Current Tax Year: If the taxpayer’s income-producing activity is a personal-service activity, they materially participated if that activity occurred during the three years before the current tax year. The three years do not have to be consecutive;
- 100 Hours and Regular, Continuous and Substantial: If the taxpayer participated in the activity for more than 100 hours during the tax year and can demonstrate based on the facts and circumstances that their activity was regular, continuous, and substantial during the tax year, then the IRS will view the taxpayer as a material participant.
Again, if a taxpayer meets only 1 of the 7 tests for material participation, that is enough for IRS purposes. Their participation can be characterized as active, and the taxpayer is not subject to the passive activity loss rules. The bad news is that a taxpayer has to pass one of the 7 tests for material participation in every tax year in which they want to avoid the passive loss rule restrictions.
There are some additional qualifications for the material participation test. Not all business activities can be used to satisfy the material participation test. These activities that cannot be used are as follows:
- Time spent as an investor, unless the taxpayer can show the time was spent on management activities;
- The activities of a limited partner in a limited partnership, unless that taxpayer can show that certain criteria are met;
- Rental activity unless the taxpayer falls within one of the two exceptions.
Of course, the rental activity exclusion does not apply to a taxpayer who is a real estate professional. The other exception is if the taxpayer actively participates in rental activities, as explained above.
Do I Need an Attorney with My Tax Problems?
Tax laws are complex and ever-changing. They involve exceptions that qualify exclusions. It can be tough to grasp IRS rules and more difficult still to apply them. And no one wants to hear from the IRS unless it is in connection with a refund. Making mistakes can lead to an unpleasant experience of a fight with the IRS.
There are various kinds of tax preparation software on the market that might help, but they cannot give you the same level of service that an experienced and knowledgeable tax lawyer can. If you are unsure about the characterization of your income or losses, you want to consult a tax lawyer for clear and confident direction.