Differences in tax treatment based on participation

The level of participation when managing real estate can determine the treatment of income and losses for tax purposes. Rental real estate is normally considered a passive activity, however, the losses generated from the rental can be deducted from ordinary income if the taxpayer can prove increased participation levels for managing the property. In some cases, net investment income tax can also be avoided for a rental activity since it will count as a business instead of an investment. If the below categories are not met, losses will count as passive which can only be netted against passive income.

Active Participation

To qualify for active participation in rental real estate, a taxpayer must own at least 10% of the property and can net all their real estate activities together to determine the amount of the income or loss. Taxpayers who meet the requirements of active participation can deduct up to $25k of losses from ordinary income, subject to phase-out based on income levels.

Material Participation

In a trade or business, material participation allows for the activity to be considered non-passive. This will determine if the taxpayer can deduct the entire loss against ordinary income. To qualify, the taxpayer must pass one of the seven tests laid out by the IRS.

1. Actively working more than 500 hours in the year.

2. Participation constitutes all or nearly all of the work in the activity.

3. Participation of more than 100 hours in the year and greater participation than anyone else.

4. The activity is a significant participation activity (more than 100 hours per activity, which exceeds 500 hours per year for all aggregated activities).

5. This level of participation has occurred in any five of the previous ten years.

6. The activity is a personal service activity and the taxpayer materially participated in any three prior years.

7. Based on all the facts and circumstances the taxpayer participates in the activity on a regular, continuous and substantial basis. The last test only applies if the taxpayer works more than 100 hours in the activity, no one else is receiving compensation for managing the activity, and no other person works more hours.

Real Estate Professional

To be an active real estate professional, one must spend at least 750 hours per year and 50% or more of services provided were performed in real property trades or businesses. Taxpayers can group together several real estate activities to achieve non-passive treatment. These can include property development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

The level of participation when managing real estate can determine the treatment of income and losses for tax purposes. Rental real estate is normally considered a passive activity, however, the losses generated from the rental can be deducted from ordinary income if the taxpayer can prove increased participation levels for managing the property. In some cases, net investment income tax can also be avoided for a rental activity since it will count as a business instead of an investment. If the below categories are not met, losses will count as passive which can only be netted against passive income.

Active Participation

To qualify for active participation in rental real estate, a taxpayer must own at least 10% of the property and can net all their real estate activities together to determine the amount of the income or loss. Taxpayers who meet the requirements of active participation can deduct up to $25k of losses from ordinary income, subject to phase-out based on income levels.

Material Participation

In a trade or business, material participation allows for the activity to be considered non-passive. This will determine if the taxpayer can deduct the entire loss against ordinary income. To qualify, the taxpayer must pass one of the seven tests laid out by the IRS.

1. Actively working more than 500 hours in the year.

2. Participation constitutes all or nearly all of the work in the activity.

3. Participation of more than 100 hours in the year and greater participation than anyone else.

4. The activity is a significant participation activity (more than 100 hours per activity, which exceeds 500 hours per year for all aggregated activities).

5. This level of participation has occurred in any five of the previous ten years.

6. The activity is a personal service activity and the taxpayer materially participated in any three prior years.

7. Based on all the facts and circumstances the taxpayer participates in the activity on a regular, continuous and substantial basis. The last test only applies if the taxpayer works more than 100 hours in the activity, no one else is receiving compensation for managing the activity, and no other person works more hours.

Real Estate Professional

To be an active real estate professional, one must spend at least 750 hours per year and 50% or more of services provided were performed in real property trades or businesses. Taxpayers can group together several real estate activities to achieve non-passive treatment. These can include property development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage.