Real Property Loss Limitations and Real Estate Professionals in California
It is quite common for a rental property to generate a loss for tax purposes, particularly where there are significant improvements made on a property, or where a property is unoccupied for a period of time. However, there may be some limitations on the amount of rental losses that are deductible in a given year, known as the “at-risk rules” and “passive activity limits” in the real estate world.
At-Risk Rules for Real Property and Real Estate
The at-risk rules can be very technical, but essentially, taxpayers may only deduct losses for the amount that is at risk in a given activity. In general, the at-risk amount in an activity is equal to the money and adjusted basis of property contributed to the activity, plus amounts borrowed for which the taxpayer is either personally liable, or for which the taxpayer has pledged property as security, other than property used in the activity. In the context of real estate, the at-risk rules may come into play to prevent an individual taxpayer from deducting losses generated from rental activities (here, the partner is not personally liable). For example, if a partnership obtains financing to refurbish a property with no personal guarantee, the partners cannot take losses generated from the improvements since the individual partners do not have any risk of loss. The disallowed losses are carried forward to the next tax year.
Do you have questions about tax law in relation to your real estate? Contact a NewPoint Law Group, LLP Roseville tax lawyer for help with your tax issues.
Passive Activity Limits
There are two kinds of passive activities—trade or business activities for which there is no material participation, and rental activities. In general, losses from passive activities can only be used to offset income from passive activities. Most real estate activities are considered passive activities, meaning that any losses generated can only be used to offset passive income. If there is no such income, the losses will be carried forward to the next tax year. Although these rules limit the amount of losses that can be claimed relating to real estate activities, there are some exceptions that may override this limitation.
Exception for Rental Real Estate with Active Participation
If a taxpayer actively participates in a rental activity, there is an exception allowing for a deduction of up to $25,000 in losses each year. Active participation is a low standard, merely requiring participation in management activities and the like. However, the $25,000 allowance is phased out for taxpayers with incomes between $100,000 and $150,000. For example, a taxpayer with $125,000 of wage income can only deduct up to $12,500 in rental losses, while a taxpayer with more $150,000 or more of wage income does not qualify for this exception at all. Any unused losses will carry forward to the following tax year.
Exception for Real Estate Professionals
Generally, rental activities are passive, even where there is material participation. However, an exception applies for qualifying real estate professionals who materially participate in the rental activity. A qualifying real estate professional is a taxpayer who performs the majority of services in real property trades or businesses, and who materially participates in real property trades or businesses for more than 750 hours during the year.
Once it is established that a taxpayer is a qualifying real estate professional, the next requirement is material participation in the specific activity at issue. Material participation can be established by satisfying any one of the seven tests provided in Temporary Regulation Section 1.469-5T(a):
the individual participates in the activity for more than 500 hours during the year;
the individual’s participation in the activity constitutes substantially all of the participation in such activity of all individuals for the year;
the individual participates in the activity for more than 100 hours during the tax year, and that individual’s participation is not less than the participation in the activity of any other individual;
participation in the activity is significant (exceeding 100 hours during the year), and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
the individual materially participated in the activity for any five tax years during the immediately preceding ten tax years;
the activity is a personal service activity (a trade or business in which capital is not a material income-producing factor), and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
based on all facts and circumstances, the individual participated in the activity on a regular, continuous, and substantial basis during the year.
For qualifying taxpayers, the real estate professional exception can free up losses that would otherwise be suspended. However, this exception has the potential to trigger an audit, so it is important to keep track of all time spent in real property trade and business activities. Keeping an activity log will help ensure that the specific timing requirements are met each year, and will be invaluable in the event of an audit.
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