Passive Loss Limitation Exemption
Passive Loss Limits
If you are invested in multiple residential properties and an active buy/fix/ hold investor, then you will come up against the $25,000 passive loss limitation imposed by the tax code in section IRC § 469(g). It is imperative that you understand IRC § 469(c)(7) for real estate professionals.
My Real Estate Professional Story
Here is my story. Two years ago I first became very active in buy/fix/ hold. I studied the rules
on capital gains vs. expenses. I trained my contractors on what to do. I kept meticulous records. I was set to deduct my passive losses against my regular income and did I need it. My husband got a new job and as part of the severance he had to cash in his stock options or lose them. We had a lot of capital gains and did not withhold money to pay the taxes since we did not expect a job change. We sent our records to our accountant and crossed our fingers.
The day came when the phone rang. I knew it was our accountant before I picked it up. I asked, “Bob, give it to me strait.” He said we owed over $15,000 in taxes. When I picked myself off the floor, I asked him how that could be? We had so many deductions? We kept good records. I expected something but not that much.
He said, “Jody you are maxed on your passive loss deductions. Your AGI put you over the amount for the $25,000 loss. We will carry the deductions to the next year.”
“No way Bob! I cannot be maxed on the passive loss deductions. I am a real estate professional.”
“I know. You gave me your Realtor® number but that does not count.”
“Bob, you did not understand me. I am an agent but I AM a real estate professional. My occupation on the tax form says property manager. According to IRC § 469(c)(7) for real estate professionals I am exempt from passive loss limitations.”
Bob agreed to re-figure my taxes and said he would get back with me at the end of the week. Later that week he called and said we will get about $5,200 back on our return. After I came down from the ceiling I thanked Bob and asked for him to e-file our return. Knowing this one section of the tax code saved me over $20,000 in taxes in one year.
Passive Loss Exemption Rules
Here’s what you need to do to qualify as a real estate professional. It is not about being a Real Estate agent. To qualify as a real estate professional, the taxpayer must spend:
- more than 50 percent of his/her time in real estate activities; AND,
- more than 750 hours in real estate activities.
- A real estate professional must materially participate in each rental activity for the loss to be deductible
How to qualify as a real estate professional
To be a real estate professional, you must spend the majority of your time in real property businesses:
- Development or redevelopment
- Construction or reconstruction
- Acquisition or conversion
- Management or operation
- Brokerage, not sales agent
One spouse alone must meet both tests. In addition, services performed as an employee do not count unless the employee is at least a 5 percent owner in the real estate business.
You can show your real estate business activities in many ways. Like with anything, it takes good record keeping.
Hint: Reduce the amount of time you work on your job. You only have to count hours as work that you actually spend doing work. Deduct vacation time from the total. Travel time does not count as work. You can deduct time you spend at meetings. In all, you may not work a full 40 hours a week for 52 weeks.
Achieve the real estate professional time requirements
Capitalize on down time to run your real estate business. Education is material and necessary for your job. You can listen to tapes to and from work. You can search for properties during lunch. Going to conferences and networking also count. Did you show a property? Place an ad? Do tenant screening? Select, hire and pay a contractor? These activities will help you get to the 750 hours.
I document all of my appointments, viewings and travel in my Tax Bot. I keep all of my expenses in there as well.
Finally, before rental losses are deductible without being limited by the passive losses rules, the taxpayer must materially participate in each rental. This can be difficult to document.
Group properties to achieve material participation
Fortunately, you are able to make a one-time election to treat all of your rental properties as a single activity. This filing is done once. Add the statement to your tax return. Even if you outsource the property management, be sure to have the contract state that you have final say on all tenants and that you must approve all expenses over a certain amount. I would do this as a matter of good business practice.
Learning these rules and executing a plan can save you thousands in taxes. I was able to put money down on another property with my tax savings for the one year alone.
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