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Forums » Tax, Legal Issues, Contracts, Self-Directed IRA » Is your real estate investing activity a "trade or business" or an investment activity?

Is your real estate investing activity a "trade or business" or an investment activity?

30 posts by 9 users

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Landlord · Seattle, Washington


I ask this question because there are real differences in what you are allowed to deduct, capitalize and report in these two situations.

Investors that are wholesaling and flipping are typically in the business of real estate.

Landlords typically are not in a "trade or business" as defined in the IRS code & regulations, but are engaged in an investment activity (Production of income).

Deductions that are reasonable and necessary in the production of rental income are not necessarily the same as what would be considered reasonable and necessary for a business.

A business would be allowed research and development costs, educational Seminars, trade shows, meals and entertainment. In the production of rental income you would in most cases have a tough time making a case that these were reasonable and necessary expenses.



Real Estate Investor · Riverview, Florida


Business Activity...I say this on several levels: The use of investment capital, growth of that capital, volume of business, and protection/separation of business and personal interests. Cash flows into our entities as capitsl investments, not as loans.

These are the things that matter to us most at this time.

Mike P.


Small_jpglogocolorlargeMichael Power, JCM Investment Holdings Inc.
E-Mail: [email protected]
Telephone: (705)984-2039
Website: http://www.jcm-investment-holdings.com


Real Estate Investor · Round Rock, Texas


Can't you just set up both Charles? I have one business for one type of income and another for another type.

Can't anyone do that?


Small_inner10_2Bryan Hancock, Inner 10 Capital
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Residential Landlord · Union, New Jersey


Hi Charles,

As a landlord my income is a form of passive income as defined by the IRS. I recently learned that due to this I do not have to give my vendors 1099s for work I had done at myy properties.

The downside is that I am lited to taking a max of 25k in passive income losses which leads me to a question: What would I need to do to be able to write off all my actual losses and not be capped at the 25k limit as set by the IRS.

thx,
chris



SFR Investor · Wheat Ridge, Colorado


You can go over the $25K if you are a "real estate professional". That's and IRS term that has nothing to do with licensing. If you spend more than 750 hours doing real estate stuff, AND you spend more time doing real estate stuff than anything else, you can claim this designation. Then you are not limited by the $25K special allowance.

If you have a full time, W2 job it will be difficult to get this, though. You would need to spend 2081 hours doing real estate stuff.


Jon Holdman, Flying Phoenix LLC


Residential Landlord · Union, New Jersey


Thx Jon. I should have clarified my question better. I am aware of the IRS "real estate professonal" designation and do not meet this.

Like you said I work full time as a systems admin with W-2 income - sometimes alot more then 40 hours a week LOL It would be very difficult to try and claim that on top of my day job I am working 2081 hours managing my properties.

thx again.

chris



Residential Landlord · Indianapolis, Indiana


I was just trying to figure out what the IRS would say about me. I am a landlord, actively involved in the management of my rentals. I had 3 units rented most of the year and I managed the rehab of a duplex to get it rent ready. I also purchase tax liens with the intention of getting the deed and adding to my rental portfolio. I think I probably could qualify for the IRS RE Pro requirements for 2011, but I didn't keep great records of my time at the beginning of the year, so I can't show proof of 750 hours. Any thoughts on whether my activities would be a trade or business for IRS purposes?



Landlord · Seattle, Washington


Originally posted by Michael Power:
Business Activity...I say this on several levels: The use of investment capital, growth of that capital, volume of business, and protection/separation of business and personal interests. Cash flows into our entities as capitsl investments, not as loans.

These are the things that matter to us most at this time.

Most of what you have described is clearly described as production of income or an investment activity for income tax purposes. For the majority of landlords they do not carry on a trade or business.



Landlord · Seattle, Washington


Originally posted by Bryan Hancock:
Can't you just set up both Charles? I have one business for one type of income and another for another type.

Can't anyone do that?

Certainly. I would advise this especially for investors that flips some properties while holding others.

Investors also need to consider the material participation rules and at risk rules in how they can impact a business or investment activity.



Landlord · Seattle, Washington


Originally posted by Chris Masons:

Hi Charles,

As a landlord my income is a form of passive income as defined by the IRS. I recently learned that due to this I do not have to give my vendors 1099s for work I had done at myy properties.

The downside is that I am lited to taking a max of 25k in passive income losses which leads me to a question: What would I need to do to be able to write off all my actual losses and not be capped at the 25k limit as set by the IRS.

thx,
chris

Landlords typically are engaged in investment activity which falls under production of income. This means they are not performing a trade or business and are not required to file 1099s for services performed for them.



Landlord · Seattle, Washington


Originally posted by Kyle Meyers:
I was just trying to figure out what the IRS would say about me. I am a landlord, actively involved in the management of my rentals. I had 3 units rented most of the year and I managed the rehab of a duplex to get it rent ready. I also purchase tax liens with the intention of getting the deed and adding to my rental portfolio. I think I probably could qualify for the IRS RE Pro requirements for 2011, but I didn't keep great records of my time at the beginning of the year, so I can't show proof of 750 hours. Any thoughts on whether my activities would be a trade or business for IRS purposes?

These activities are investment activities and as such would not be treated as a business. You want to take care when filing as a real estate professional. You want to be able to document that you have met each of the tests involved.

For most people that work a full time job it would be difficult to work enough to qualify as a real estate professional.



Real Estate Investor · Round Rock, Texas


Originally posted by Charles Perkins:
Certainly. I would advise this especially for investors that flips some properties while holding others.

Charles...would you mind giving the non tax wizards a refresher on this? I tried looking through some material this evening, but everything is quite confusing.

It seems to me you get to deduct losses in full traded against SE tax on ordinary income and no 1031 exchanges if you are a dealer/professional.

It also seems to me you get no SE tax and eligibility for 1031s traded against losses against ordinary income capped at $25k if you are a NON dealer/professional.

So what happens if you are both? What happens if you are a dealer in one business and not in the other? Do you get the best of both worlds?


Small_inner10_2Bryan Hancock, Inner 10 Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://www.inner10capital.com/invest/
Join Our Investor Base - Currently Growing 12% Per Week


Landlord · Seattle, Washington


Yes, it is possible to enjoy the best of both worlds.

Landlords in general have passive income activity. If they actively participate in their rental activity they can take up to a 25,000 loss against ordinary income each year. The 25,000 maximum though is reduced for those whose adjusted gross income(AGI) exceed 100K $1 for every $2 that exceeds that amount. This means no loss is allowed against ordinary income for those with an AGI of 150K or more.

Keeping your business activity separate from your passive activity is extremely important. Someone flipping several properties and holding onto several properties for rentals may find that all of there income is treated as a business and they lose some of the benefits of passive activities.

Flippers are not able to do a 1031 exchange because there real estate is essentially inventory and inventory is not eligible for 1031 treatment. Flippers pay SE tax and are not limited on the loss they can take in a year. Real estate is also treated as ordinary income when it is sold rather than having special capital gains treatment.

It is extremely important to know what is a business activity and what is an investment activity. These activities must be separated or an investor may find that they are subject to unfavorable tax consequences. Often times it is 2 to 3 years after the fact that an audit may come up and if the IRS sees substantial errors in one year they usually open up several more.



Real Estate Investor · Round Rock, Texas


Thanks Charles...so what qualifications does one need to meet to get the best of both worlds? Can you be a professional for the trade activities and a passive investor for the non-trade activities simultaneously? It seems you can as long as you meet the professional requirements.

I know this is a little off topic, but if one sets up a solo K and they are both a professional and a passive investor should the plan be adopted by both businesses? In other words would their s-corp trade business and their passive LLC both adopt the plan and bury money separately?

I know that there are UBIT consequences for using 401(k) dollars to invest in the trade business. Could one bury some of the s-corp income and use it to invest in the passive business if they have the best of both worlds with separate businesses?


Small_inner10_2Bryan Hancock, Inner 10 Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://www.inner10capital.com/invest/
Join Our Investor Base - Currently Growing 12% Per Week


Landlord · Seattle, Washington


It would be difficult, but possible to be both a real estate professional and an investor. Typically though you find business activity is flipping, wholesaling or developing. Rental activity is most often passive because most don't qualify as real estate professionals.

While it is possible to utilize LLCs and S corps to shift money and possibly avoid taxes most of these transactions would be disallowed. The IRS is big on "substance over form." If you can show no economic reason for a transaction you risk the IRS treating the transaction as though it never occurred.



Real Estate Investor · Round Rock, Texas


Why is it difficult Charles? If you are a professional can't you just invest some money in passive ventures and get the best of both worlds?

I'm not advocating shifting money around. Can't you just run your development deals, flips, etc. through your s-corp and your rentals through your LLC? If you are a professional doesn't that give you the best of both worlds?

Do people normally set solo Ks up for both business types if they wish to act in the most tax efficient manner?


Small_inner10_2Bryan Hancock, Inner 10 Capital
E-Mail: [email protected]
Telephone: 1-800-577-0401
Website: http://www.inner10capital.com/invest/
Join Our Investor Base - Currently Growing 12% Per Week


Landlord · Seattle, Washington


Originally posted by Bryan Hancock:
Why is it difficult Charles? If you are a professional can't you just invest some money in passive ventures and get the best of both worlds?

When I say real estate professional I mean a landlord that qualifies as a real estate professional for passive activities. To qualify on that basis and have other rentals that you do not want to include would be difficult.

Originally posted by Bryan Hancock:
I'm not advocating shifting money around. Can't you just run your development deals, flips, etc. through your s-corp and your rentals through your LLC? If you are a professional doesn't that give you the best of both worlds?

That's exactly what I would advocate. This strategy does give you the benefit of both worlds and provides the necessary separation between these activities.

Do people normally set solo Ks up for both business types if they wish to act in the most tax efficient manner?

As I understand it flipping in a solo K can be problematic. There are far more knowledgeable people here on the subject of self directed 401Ks. Hopefully they will chime in.



Residential Landlord · Indianapolis, Indiana


Originally posted by Charles Perkins:
Originally posted by Kyle Meyers:
I was just trying to figure out what the IRS would say about me. I am a landlord, actively involved in the management of my rentals. I had 3 units rented most of the year and I managed the rehab of a duplex to get it rent ready. I also purchase tax liens with the intention of getting the deed and adding to my rental portfolio. I think I probably could qualify for the IRS RE Pro requirements for 2011, but I didn't keep great records of my time at the beginning of the year, so I can't show proof of 750 hours. Any thoughts on whether my activities would be a trade or business for IRS purposes?

These activities are investment activities and as such would not be treated as a business. You want to take care when filing as a real estate professional. You want to be able to document that you have met each of the tests involved.

For most people that work a full time job it would be difficult to work enough to qualify as a real estate professional.

So I don't need to send 1099s for 2011? I am not going to claim RE Pro since I lack the records, but I am going to keep better records for 2012 and expect to claim RE Pro for the year. Is that the threshold for a landlord to have trade/business instead of investment?



Landlord · Seattle, Washington


Since you are not a trade or business you are not required to send out 1099-misc. The legislation passed in 2010 that mandated landlords to send these out was repealed.



Real Estate Investor · Southlake, Texas


Charles, if I worked full time in the real estate business, management, development, leasing, would that qualify me as a RE Professional as it relates to my personal REI?


Tod R., Thompson Realty Corporation
Telephone: 817-781-1942
Website: http://www.thompson-realty.com
[email protected] http://www.thompson-realty.com




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