Rental activities are consider passive activities by definition and thus are subject to passive activity loss limitation rules. The taxpayer's level of participation in their rental real estate activities impacts how losses are treated in the tax return. Two important terms need to be understood: active participation and real estate professional.
A taxpayer is considered to actively participate in rental real estate activity if the taxpayer, and the taxpayer's spouse if filing joint, own at least 10% of the rental property and make management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, and approving expenditures.
In TaxSlayer Pro, indicating that the taxpayer actively participates is done on a property-by-property basis, and active participation is assumed by default when a property record is created. To check and/or update this info for a property, select to edit the property from the Schedule E menu, then from the property's "Schedule E - Rents & Royalties Edit Menu" select:
- Supplemental Income Questions
- Did You Actively Participate? - Indicate YES or NO as needed.
Real Estate Professional
Activities of real estate professionals are not treated as passive activities. The taxpayer qualifies as a real estate professional if both of the following conditions are met:
- More than half of the personal services the taxpayer performed in all trades or businesses during the year were performed in real property trades or businesses in which the taxpayer materially participated, and
- The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participated.
Real property trades or businesses include the following:
- property development and redevelopment
- construction and reconstruction
- operation and management
Services the taxpayer performed as an employee are not treated as performed in a real property trade or business unless they owned more than 5% of the stock or more than 5% of the capital or profits interest in the employer. For a return being filed married filing joint, either the taxpayer or spouse must meet both of the above conditions without taking into account services performed by the other spouse.
In TaxSlayer Pro, indicating that the taxpayer is a real estate professional is done on a property-by-property basis. To indicate this status for a property, select to edit the property from the Schedule E menu, then from the property's "Schedule E - Rents & Royalties Edit Menu" select:
- Supplemental Income Questions
- Disposed of Property or Eligible Real Estate Professional? - Answer YES.
For the purpose of determining material participation as a real estate professional, the taxpayer's rental real estate activities are treated separately (and the taxpayer must indicate they are a real estate professional for each property as above). However, the taxpayer can elect to treat all interests in rental real estate as a single activity. This election is made pursuant to 26 CFR §1.469-9(g). (Depending on the taxpayer's circumstances, not making this election could potentially trigger passive loss limits even though they are real estate professional.)
To make the election in TaxSlayer Pro, the taxpayer must file a statement with the original income tax declaring that he or she is a qualified taxpayer for the taxable year and is making the election to treat all interest in rental real estate as a single rental real estate activity pursuant to IRC section 469(c)(7)(A). The election is binding for the taxable year it is made and for all future years whether or not the taxpayer continues to be a qualifying taxpayer.
To produce the election statement, from the Main Menu of the tax return (Form 1040) select:
- Schedule E
- IRC Section 469(c)(7)(A) Election - answer YES to make the election
In addition to being sent to the IRS in the e-filed return, the election is also available for printing under the View Results menu.
The election can be revoked in the year in which the taxpayer's facts and circumstances have materially changed from the taxable year in which the election was made. (While the IRS hasn't provided examples of a "material change", they do note that a material change doesn't include (a) the election being less than advantageous or (b) a break in the taxpayer not qualifying as a real estate professional.)
To revoke the election, from the Main Menu of the tax return (Form 1040) select:
- Miscellaneous Forms
- Elections Explanations (sent to the IRS) - Select New and create a statement indicating (a) the election under Section 469(c)(7)(A) is being revoked and (b) explaining the nature of the change in facts and circumstances.
Special Allowance for Rental Real Estate Losses
If a taxpayer is not a real estate professional but actively participates in a rental activity that has a loss, they may be able to deduct up to $25,000 of the loss against their nonpassive income ($12,500 if married filing separately). The special allowance calculation is included in Part II of Form 8582.
Determining if the taxpayer qualifies for the special allowance involves calculating their modified adjusted gross income. Modified AGI equals AGI excluding the following items:
- Passive income or loss included on Form 8582
- Rental real estate loss allowed if they are a real estate professional
- An overall loss from a PTP
- Taxable social security and tier 1 railroad retirement benefits
- Deductible contributions to a traditional IRA or a section 501(c)(18) pension plan
- The deductible part of self-employment taxes
- Interest from series EE and I U.S. savings bonds used to pay higher education expenses that was excluded from income
- Amounts received under an employer's adoption assistance program that were excluded from income
- The student loan interest deduction
- The deduction for foreign-derived intangible income and GILTI
If the taxpayer’s modified AGI is $100,000 or less ($50,000 or less if married filing separately), the loss is deductible up to $25,000.
If the taxpayer’s modified AGI is more than $100,000 ($50,000 if married filing separately) but less than $150,000 ($75,000 if married filing separately), the special allowance is limited to 50% of the difference between the taxpayer’s modified AGI and $150,000 ($75,000 if married filing separately).
There is no special allowance if the taxpayer's modified AGI is $150,000 or more ($75,000 for married filing separately).
Note that a married individual filing separately must have lived apart from their spouse for the full year to qualify.
Taxpayers should keep good records regarding their real estate activities to support both time and money spent, particularly if they are claiming to be a real estate professional. These records will be invaluable if the IRS examines their return and inquires about how it was prepared.
Note: This is a general guide on rental real estate participation. This is not intended as tax advice.