Can Real Estate Professional Status Free Up Old Passive Losses?
Can Real Estate Professional Status Free Up Old Passive Losses?
Many tax code–defined real estate professionals wonder if they can immediately use prior passive losses once they qualify for real estate professional status. The short answer is no, and here’s why.
IRC Section 469 Background
IRC Section 469 limits your ability to deduct passive losses to offset non-passive income, such as wages, interest, and dividends. The passive activity rules particularly impact real estate rentals, which are per se passive by default.
If you materially participate in a business, its income or loss is considered non-passive. But most rental losses remain passive, regardless of your involvement, unless you qualify for an exception.
Passive losses adhere to the following three principles:
- Passive losses offset only passive income.
- Excess passive losses are disallowed and carried forward to offset passive income in future tax years.
- Carried-forward passive losses are released in a complete disposition, allowing them to offset both passive and non-passive income.
Example: John, a doctor earning $500,000 annually in non-passive income, generates a $50,000 loss from his rental property in Year 1. He cannot offset this loss against his medical income due to the passive loss rules. In Year 2, he sells the property for $100,000 capital gain.
As a result:
- John deducts his $50,000 suspended ordinary loss against his high ordinary income (e.g., his medical practice income).
- John pays taxes on his $100,000 capital gain at the more favorable capital gains tax rate.
Key point
For John to deduct the $50,000 loss in Year 1, he would have to (1) be a tax code–defined real estate professional who (2) materially participated in his rental property activity.
What Is a Tax Code–Defined Real Estate Professional?
The tax code real estate professional exception is Part 1 of a two-part solution that allows you to treat rental losses as non-passive. To qualify as a tax code real estate professional, you must
- Spend more than half of your working time in real property trades or businesses (50 percent test); and
- Perform at least 750 hours of work in real property trades or businesses during the tax year (750-hours test).
Special rule for employees. When counting real property work time for the 50 percent test and the 750-hours test, the W-2 employee must have more than a 5 percent ownership interest in the rental or other real property business.7 With 5 percent or less ownership, the work time counts as work time but not as rental or other real property trade or business work time.
The IRS defines “eligible real property businesses” as those engaged in
- Development or redevelopment,
- Construction or reconstruction,
- Acquisition,
- Conversion,
- Renting or leasing,
- Property management, or
Meeting the two requirements makes you a tax code–defined real estate professional. It’s the first step to making your rental activities non-passive.
But to deduct your rental losses against all your income, you must also pass Part 2 of the solution. Part 2 requires that you materially participate in your rental activities. For clarity on “material participation” in a rental property business, see Know Why the Court Denied Losses on Four of Six House Rentals.
You can deduct rental losses against all income when you meet the two-part solution: Part 1 (the 50 percent test and the 750-hours test) and Part 2 (the material participation test).
Example: Debbie, a real estate broker earning $500,000 in non-passive income, incurs $100,000 in rental losses. Her real estate brokerage firm, which she owns, helps her pass the tax code–defined real estate professional test. She also passes the material participation test because she is the only person who works on the rentals. Accordingly, she deducts the $100,000 in losses against her non-passive brokerage income.
Former Passive Activities
What happens to prior passive losses from years before you qualified as a real estate professional?
Unfortunately, those losses remain passive. Real estate professional status applies to the current year only and must be tested annually. Prior passive losses fall under the “former passive activity” rules in IRC Section 469. You can use the prior losses in three ways:
- Offset income from the same activity.
- Offset passive income from other activities.
- Deduct the losses upon a complete disposition of the activity.
Example: John, our doctor from the example above, generates $50,000 in rental losses in Year 1; the tax code suspends them under the passive loss rules. In Year 2, when the rental activity incurs $60,000 in rental losses, his wife, Susan, (1) qualifies as a real estate professional and (2) materially participates in the rental activity.
As a result:
- On their joint tax return, John and Susan deduct the $60,000 rental loss.
- The $50,000 rental loss from Year 1 remains trapped (suspended) by the passive loss rules and cannot be used until it offsets rental income or the property is sold.
Takeaways
Real estate professional status is not retroactive. Qualifying as a tax code–defined real estate professional does not free up prior suspended passive losses.
Annual testing is required. Real estate professional status applies on a year-by-year basis. To deduct rental losses against non-passive income, you must meet the 50 percent test, the 750-hour test, and the material participation requirement annually.
Prior passive losses remain subject to restrictions. You benefit from previous years’ passive losses when you
- generate passive income, or
- dispose of your entire interest in rental activity.
At Provident CPAs, we specialize in helping clients adapt to changing economic conditions. Whether you’re a business owner or an individual looking to optimize your tax strategy, our team is here to guide you through the complexities of today’s tax landscape. Contact us today to learn more about how we can help you achieve financial independence, even in the face of economic uncertainty.