How can i show "Material participation" to claim passive losses?

Question

So i was researching about passive losses and i found out that i cant claim passive losses if i dont materially participate in the property or (if i am not a real estate professional). How can you show material participation if all the management work is done by the property management company?Also can you deduct property management fees from your taxes?

Harry M. · Answer

Disclaimer - I'm not a tax expert. Below is my understanding of how it works, but please verify independently.

Vaishal, to build on what Xing said, it sounds like you are mixing up expenses and losses. Suppose a hypothetical investor earns $12,000 in a year from his property, but has expenses*** of $13,000. His expenses are 13,000, his loss is 1,000. 
He can deduct expenses on the 12,000, but not the final 1000, which would result in a tax bill of $0. The reason he can't deduct the final thousand is because he has nothing to deduct against. He never earned that thousand, so he wouldn't otherwise pay taxes on it anyway, since he never had it in the first place.

Now, suppose that the hypothetical investor also has a day job at which he earns $80,000. Now he can deduct the 1,000 against that income. That is what is referred to as deducting a passive loss. This can be done up to a limit of $25,000 worth of passive losses. Anything above that cannot be deducted. Instead it is carried over and deducted against next years income instead.

As soon as a person has an income of $100,000, the ability to deduct the passive losses begins phasing out at a rate of $1 per $2 over the 100k threshold. So a person earning 120k would only be able to deduct 15k of passive losses, and the rest would have to be carried over to be deducted from the income of future years. By the time your income reaches 150k, the ability to deduct passive losses phases out completely. Now any passive losses must be carried over, and can only be deducted from future years passive income, not from employment income.

If a person is a real estate professional, the 25k cap and phase out don't apply. Showing material participation is one of the hurdles to meeting this designation - another is hours worked (can't remember the exact number, but it is significant), and that more hours are spent as a real estate professional than in any other endeavour.

***Note that expenses can include paper expenses such as depreciation. So in the example, the investor might still have some money in his pocket despite expenses exceeding his income. This is one of the reasons why real estate is considered an attractive vehicle for building wealth.

Vaishal Patel · Answer

Steven Hamilton II,Harry M.,Xing Zhu Chris Masons - Thanks..i get it now :)

Steven Hamilton II · Answer

Vaishal Patel,

If your income is below 100k you will be able to take the deductions; however, once you surpass 100k you will not be able to take them due to not participating materially.

How can you show material participation if all the management work is done by the property management company?Also can you deduct property management fees from your taxes?

This is a strong audit topic for the IRS.

If you are having a management company handle the property, you are not going to be materially participating.

From the IRS audit manual:

A trade or businesses is a passive activity if the taxpayer does not materially participate.  The taxpayer materially participates if and only if he or she meets one of the following seven tests provided in Reg. § 1.469-5T(a).  See checksheet and log at end of chapter.
The taxpayer works 500 hours or more during the year in the activity.
The taxpayer does substantially all the work in the activity.
The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
The taxpayer materially participated in the activity in any 5 of the prior 10 years.
The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.[3]
Note: The first four tests look to a set number of hours of participation in the tax year.  The next two tests look to material participation in prior tax years.  The final test looks to the facts and circumstances, but is highly restrictive.

So lets say if i am paying 150$ or 10% out of the 1500 i collect from rent to the management company..can i deduct all 150*12=1800$ from my taxes?

You can deduct the payments to the management company.

Xing Zhu -what do you mean by "Of course, the sum of all deductions cannot exceed your rental profit."?

This means that you cannot take a deduction that exceeds the rent brought in.  Ex.  If you bring in 15,000 in rent. You can only deduct in the current year 15,000 in expenses.  You WILL list all expenses; however, the loss cannot be taken that year. The remaining deductions will carry forward until they can be used. They are typically used in the year in which you sell the property.

You definitely need to consult a tax professional.

-Steven C. Hamilton II EA

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Passive-Activity-Loss-ATG---Chapter-4,-Material-Participation

Xing Zhu · Answer

Let  us say if your gross rental income is $1000. Your expenses
including management fees, repairs, etc., mortgage interest and other investment interest etc., and property depreciation total is X=$800, then you pay taxes only on $200. If X=$1515, then you pay taxes on $0 for rental, and you CARRY OVER the disallowed amount $515 for future deductions.

Vaishal Patel · Answer

Xing Zhu -what do you mean by "Of course, the sum of all deductions cannot exceed your rental profit."?

so lets say after all the expenses and mortgage if i am making 50$ profit/month...does that mean i can only claim deductions upto 12*50=600$? or even worst if i am breaking even..does that mean i cant claim any deduction?Thanks :)

Xing Zhu · Answer

What you paid to management company is deductible. Of course, the sum of all deductions cannot exceed your rental profit.

If your management company manages your property, you are not materially participating.

Chris Masons · Answer

HI Vaishal,

While I self manage all my properties which would qualify me for "material participation, you can definitely write off your 150 per month fee for management as this is a legitimate business expense. I think that bc you have a Management CO in place you do not qualify for the 25k in passive loss allowance. I could be mistaken however and would wait for a tax expert such as Steve to chime in.

good luck!

Chris

Vaishal Patel · Answer

So lets say if i am paying 150$ or 10% out of the 1500 i collect from rent to the management company..can i deduct all 150*12=1800$ from my taxes?

How can i show "Material participation" to claim passive losses?

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