Rental Income : Tax Issues

In the jargon of IRS, any rental activity is considered passive. A passive activity is one that involves trade or business in which the tax payer does not materially participate. There are various tests for determining material participation. But the two common ones are: The individual participates in the activity for more than 500 hours during the year; or more than 100 hours during the year and no other individual participates more than the taxpayer.

Any rental activity is passive whether or not the taxpayer materially participates. Passive activity losses generally cannot offset income from non-passive sources such as salaries, business income in which taxpayer materially participates, or portfolio income. Passive losses can only be offset with passive income. Passive losses in excess of passive income are suspended and carried forward indefinitely to offset future passive activity. However, as explained below, there are special rules for real-estate rental activities and real-estate professionals.

Active Participation in Rental Real-Estate Activity: A special rule for rental real estate activities may allow the first $25,000 of net passive losses from rental real estate to offset the taxpayer's non-passive income. This maximum amount of $25000 may get reduced, but not below zero, by 50% of the amount by which adjusted gross income exceeds $100,000. To qualify for the $25,000 loss, the taxpayer must actively participate in the rental activity and also have at least 10% ownership interest. The active participation standards are less stringent than those for material participation. The taxpayer should be making management decisions or arranging for others to perform services such as repairs.

Real-Estate Professionals: Real-estate professionals treat passive rental real-estate losses as non-passive activities and can use these losses to offset wages, interest, and non-passive income. The individual needs to meet the two tests to qualify as a real-estate professional. First, more than 50% of personal services during the year must be performed in real-property trades or business in which the individual materially participates. Second, the individual must perform more than 750 hours of service in those same trades or businesses. California does not conform to real-estate professional rules.

Material participation: Material participation plays a key role in two distinct aspects of the relief professionals. First, when determining whether the taxpayer qualifies as a real estate professional, only real-property trades or businesses in which the tax-payer materially participates are counted. Second, once it is determined that the taxpayer qualifies as a real-estate professional, the non-passive treatment is available only for rental real-estate activities in which the real-estate activities in which the real-estate professional materially participates.

Election to Combine Rental Real-estate Activities: A taxpayer can elect to treat all interests in rental real-estate activities as one activity. This election can be made any year the special real-estate professional rules apply. Once the election is made, it is irrevocable. Failure to make an election to treat multiple rental properties as a single activity may make losses passive and get suspended. A realtor who also owns many properties may qualify as a real-estate professional. He may have worked enough hours to be a material participant in aggregate but not for each property and may not get the benefit of deducting rental real-estate losses.