Investors can typically deduct only as much of their passive income for the year from investments like real estate in which they have no material involvement.
When so-called “real estate professionals” claim significant deductions for rental real estate losses, the IRS frequently examines these claims. The Tax Court denied losses in a recent case involving a couple that fully owned a partnership because neither spouse satisfied the necessary tax law test, Dunn, TC Memo 2022-112, 11/29/22.
Investors typically are only permitted to deduct expenses up to their annual passive income for investments like real estate in which they have no material involvement. As a result, they are not eligible to deduct any passive activity losses (PALs), despite real estate investors who qualify as “active participants” being able to write off a small portion of their PALs.
If you are an active participant, you can typically use up to $25,000 of loss to reduce non-passive income. But if your modified adjusted gross income (MAGI) is between $100,000 and $150,000, the $25,000 offset gradually disappears. It should be noted that this phase-out provision is not inflation-indexed.
You can deduct a loss from non-passive income, just like any other business, if your real estate activities qualify you as a real estate professional. There are two main requirements for becoming a real estate professional.
1. You perform more than half of your personal services in all trades or businesses during the tax year in real estate trades or businesses in which you have a material interest.
2. You must devote at least 750 hours to your real estate trades or businesses.
Activities related to real estate in which you have a material interest are not considered passive activities as long as you pass this two-part test. However, the IRS strictly adheres to the letter of the law.
The new case’s facts: A married couple from Georgia formed a partnership to manage their real estate properties. During the tax years in question, each spouse worked full-time.
For 2013 and 2014, the couple submitted joint tax returns. Regarding the real estate properties covered by the PAL rules, they reported losses of $85,260 and $48,740, respectively. Logs that the couple produced allegedly depict their joint real estate rental activities during that time.
The logs indicate that 407 hours were worked in 2014 compared to 767 hours in 2013. The logs did not, however, indicate which spouse worked these hours. The Tax Court further alleged that the hours listed in the logs were exaggerated to include hours spent actually present at the properties.
Which of the couple meets the requirements to be a real estate professional? The facts were examined by the Tax Court.
First, the couple argued that they both invested more than half of their personal services in real estate-related trades or businesses. The Tax Court, however, disagreed. This conclusion was not supported by the evidence.
Second, the couple claimed that they had completed the 750-hour requirement. Only one spouse must have accumulated 750 hours in order to satisfy this requirement. The Court was not persuaded that either spouse met this requirement, though. The Tax Court concluded that the standard for real estate professionals was not satisfied as a result.
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