Real estate by default is treated as a passive activity for income tax purposes. This means that passive income is included in Adjusted Gross Income, however, passive losses can only be offset by other passive income. In many cases, real estate investing can produce tax losses, and while taxed as a passive activity, the use of these losses is limited.
There may be creative methods to enjoy passive losses. The two which immediately come to mind are if you already have another passive stream against which to deduct passive losses or creating your own passive income stream. Such creativity will be quite involved, so this is not the focus of today’s topic.
Tax losses from real estate can only be fully enjoyed on your tax return if the activity is non-passive. For purposes of our discussion, tax losses may not reflect your actual profit in the activity. We hope that your real estate ventures are profitable, and at the same time, we recognize that there are significant tax benefits to investing in real estate.
How can real estate income and losses be treated as a non-passive activity? For this discussion, non-passive is another term for active activity or material participation. For the most part, changing the nature of real estate from passive to non-passive is objectively measured.
The primary benchmark for material participation is 500 hours annually. There are some exceptions to the 500 hour test. The most notable exception is that you only have to log 100 hours annually if you also have documented time logs for everyone else (non-owners) who rendered services to your investment properties, and – this is important – their time cannot exceed yours. In other words, the activity cannot consume more than 200 hours per year, which is extremely challenging for certain types of real estate, especially short-term rentals.
Unfortunately, real estate activity is still treated as passive income even with material participation. Thus, material participation alone is insufficient.
The status needed to flip real estate activities from passive to non-passive is Real Estate Professional Status. This is claimed on your individual income tax return for property investments taxed on your individual income tax return (Schedule C or E) or through a pass-through entity (i.e., Partnership or S Corporation). Real Estate Professional Status requires logging a minimum of 750 hours annually and at least one-half of all time invested in all income-producing activities.
This means that, by default, a Real Estate Professional cannot be employed full-time and achieve Real Estate Professional status. This is because 750 hours per year are less than your full-time employment. Thus, even if you were able to work 1,500 to 2,000 in full-time employment and log an additional 750 hours in your real estate investments, you would still not qualify because less than half of your time invested in income-producing activities was in your real estate investments.
An example of this is with a married professional, such as physician, attorney or accountant. If the spouse is not employed, the spouse is able to invest 750 hours in the real estate activity. Because this is the spouse’s only income-producing activity, the spouse will qualify as a Real Estate Professional upon logging 750 hours. The spouse could also hold part-time employment, so long as that employment is less than 750 hours.
There are several notable points we should include here as well.
- Material participation qualifies the taxpayer for the Qualified Business Income Deduction (QBI). This is a favorable deduction against taxable income.
- Hours invested must be recorded in writing on time logs. This is very important and has been addressed very clearly and affirmatively in the U.S. Tax Court. Similar to mileage logs, time logs must show the date, amount of time, purpose or use of the time, and where the time was spent. The log is not required to be in any specific format, however, the log must not give opportunities for questions. An insufficient time log will undermine a claim to material participation and can give the IRS reason to assess underreporting or accuracy penalties. If your tax return is audited, you should expect that the revenue agent will request your time logs!
- The property owner’s time must be the largest amount of total time invested if others are also servicing the properties. This includes contractors (or subcontractors) and those engaged for general repair or cleaning. Their time can easily be logged and tracked through invoices showing the amount of time billed.
- Short-term rentals do not count toward Real Estate Professional Status. This is because short-term rentals are not considered to be a real estate activity. Short-term rental activity may be a business, and this by nature will already be treated as non-passive. If your objective is to flip passive income/losses to non-passive, focus on long-term rentals and real estate investing other than short-term rentals. Short-term rentals include Air BNBs.
- Even if filing a joint income tax return, the time invested by one spouse permits both spouses to enjoy Real Estate Professional Status.
- Be cautious of videos and articles on the internet and advice from non-tax professional friends. There are posts, for example, claiming that simply owning a short-term rental qualifies for Real Estate Professional Status. This is incorrect and misleading. You must also prove material participation in conjunction with the activity.
To summarize, real estate income is flipped from passive to non-passive primarily by logging 750 hours annually. Upon successfully achieving Real Estate Professional Status, you will be able to utilize tax losses from real estate investments against other, non-real estate and non-passive income.
If you have questions about time logs, the amount of time required and the time invested by people you may hire, it is best to obtain the advice of a knowledgeable tax professional.