Are You Ready to Turn Pro? Maximizing Rental Losses by Electing to Become a Real Estate Professional

By Baker Newman Noyes November 4, 2012

With the sun-setting of the Bush era tax cuts at hand, many taxpayers will be facing an increased tax bill in the coming years. Some ways taxpayers can protect themselves from such an increase would be to make better use of currently available deductions and elections. One such election is the Real Estate Professional Election in relation to rental real estate income and losses.

Under current tax law, rental real estate income and loss on a personal tax return is considered passive in nature. Passive activity income and losses simply defined is income or losses generated from investments in which the taxpayer puts forth minimal effort to maintain. This characterization of rental income and loss is important because passive losses from rental activities can be deducted only if they offset other passive income; passive losses generally cannot offset other sources of income (business, wages, etc.).  Thus, a taxpayer often won’t be able to take full advantage of rental losses to reduce their tax burden.  Instead, unused losses are carried forward for potential use in later years.

Enter the real estate professional election

The Real Estate Professional Election gives the taxpayer the ability to claim rental losses against other sources of income. To qualify for this election the taxpayer must meet two requirements: 1) More than one-half of personal services performed during the year were in real estate trades or business, and, 2) the total of that time spent in a particular activity is greater than 750 hours. The term “real estate trade or business” includes time spent beyond pure rental activities, such as time spent developing, constructing, acquiring, managing, leasing, etc.

The requirement of spending 750 hours on one particular activity may present a challenge to many taxpayers who may own several rental properties. Another election is available to taxpayers whereby they may combine all rental activities into one activity for the purpose of meeting the 750 hour requirement.  If a taxpayer has multiple rental properties but does not spend 750 hours on any one rental, he or she can elect to group the rentals together so the collective hours spent are greater than 750.  This allows the grouped activities to be considered non-passive.

Potential downside to making the election

Some potential negative consequences may result from making this election. If the taxpayer has other non-rental passive losses (limited partnership losses, for example) they will not be able to offset those losses against rental income, as they would normally be able to do. Another detractor is if the taxpayer elects to group their rentals, they must continue to do so in future years unless their business substantially changes. This means that absent any changes, a taxpayer cannot annually pick and choose which separate rental activities to designate as active or passive to maximize their tax benefit.

With higher tax rates looming, the Real Estate Professional Election is just one of the many options taxpayers have available to lower their tax burdens. As everyone’s situation is unique, it is always best to speak with your tax advisor about the various options available to you and work with him or her to achieve the best possible solution.

If you would like to discuss further, please call Andy Smith or your BNN advisor at 1.800.244.7444.