Even if you have strong positive cash flow from your rental
real estate, chances are you still have a loss for tax
purposes due to the depreciation deduction.
This is a great tax strategy because your positive cash
flow is sheltered from tax. But, it can be even better if
you are able to take your losses against your other income
(like your income from your job or the business that you
run).
The general rule for rental real estate losses is that they
are passive. This means they can only be taken against
passive income. The income from your job and the business
you run is active income so your rental losses cannot
shelter this income. However, there are two exceptions to
this rule.
** Exception #1: "Active Real Estate" exception. **
The Background on the Active Real Estate Exception
Rental real estate, in many cases, is held to provide
financial security to individuals with moderate incomes.
Because of this Congress believed that a rental real estate
investment in which a taxpayer has significant
responsibilities and which served a significant non-tax
purpose should be treated differently than the activities
meant to be limited under the passive loss provisions. So
Congress created the active rental real estate exception.
- How It Works -
If you are active in your rental real estate activities you
may be able to deduct up to $25,000 of your rental losses
against other ordinary income. We say may be because there
are income limitations which phase out the $25,000
deduction. The phase out will start when your adjusted
gross income exceeds $100,000 and end when your adjusted
gross income is at $150,000. This means that for every $2
over $100,000 of adjusted gross income you will lose $1 off
the $25,000 deductible amount. For example if your
adjusted gross income is $120,000 you will have to reduce
the $25,000 exception by $10,000 and the most rental real
estate losses you can deduct will be $15,000 for that tax
year.
Don't let your high income penalize you! Learn my tax
secrets to increase your cash flow by uncovering the hidden
cash flow in your real estate. Several of my secrets
reveal how to legally get around these income limitations!
What constitutes active participation?
Active participation exists so long as you participate, in
the making of management decisions or arranging for others
to provide services (such as repairs), in a significant and
bona fide sense. Also, you must have at least a 10%
interest in the activity at any time during the year.
** Exception #2: "Real Estate Professional" exception. **
What is a Real Estate Professional?
First, let's dispense with one myth: Real Estate
Professional status does not mean you have to hold a real
estate license. Rather, it is a designation you obtain by
meeting certain specific requirements. If you qualify as a
real estate professional you can deduct all your current
year rental real estate losses against other income without
limitations.
Requirement #1
The first requirement is that you spend more than 750 hours
in real estate trades or businesses in which you materially
participate.
What is a real estate trade or business? A real estate
trade or business is defined as ANY real estate
development, redevelopment, construction, reconstruction,
acquisition, conversion, rental, operation, management,
leasing, or brokerage trade or business.
The 750 hours test must be met for each activity. So for
example, say you have three rental properties. The general
rule is that you have to perform at least 750 hours on
activities related to EACH of those three properties.
Fortunately, there is an exception to this rule. If you
make the election to aggregate all of your rental real
estate activities into one activity, you only have to meet
the 750 hours requirement once for the tax year.
What types of activities qualify as real estate
professional activities? Activities such as:
- Searching for possible rental properties
- Attending real estate seminars or reading real estate
books
- Meeting with real estate agents and viewing properties
- Meeting with mortgage brokers with regards to getting
loans on properties
- Travel time to and from the seminars and your property
searches
- Preparing your bookkeeping and tax information for your
rental properties
- Time spend buying or selling properties (i.e. signing the
closing documents)
- Studying and reviewing financial reports (Investor-type)
- Preparing summaries or analyses for personal use
(Investor-type)
- Monitoring finances or operation in a non-managerial
capacity (Investor-type)
An important note to the investor-type activities mentioned
above is that these activities can only be counted towards
real estate professional time if you are involved in the
day-to-day operations or management of the activity for
which you perform those tasks. Essentially, this means
that if you have an independent property manager and your
only real estate business is your rental properties, you
probably will not qualify as a real estate professional.
Requirement #2
The second requirement is that you spend more time in your
real estate trades or businesses than in ALL OTHER trades
or businesses combined. Time spent as an employee in real
estate activities is counted only if you are a more than a
5% owner in that business.
- What You Need to Do -
You have to meet the above requirements each year. So, you
could be a real estate professional one year but not the
next. Only one spouse needs to meet the requirements in
order for a married couple to take advantage of the
benefits provided by the real estate professional status.
The extent of an individual's participation in an activity
may be established by any reasonable means. Contemporaneous
daily time reports, logs, or similar documents are not
required if the extent of such participation may be
established by other reasonable means. Documentation
required includes the identification of services performed
over a period of time and the approximate number of hours
spent performing such services during such period, based on
appointment books, calendars, or narrative statements.
If you are audited, the IRS will ask you to prove your real
estate professional status. For more on how to be
prepared, see my recent article titled: "Three (3) Things
You Can Do To Be Prepared For An Audit"
----------------------------------------------------
Tom Wheelwright is not only the founder and CEO of
Provision, but he is the creative force behind Provision
Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth,
business, and tax strategies. Along with his frequent
seminars on such strategies, Tom is an adjunct professor in
the Masters of Tax program at Arizona State University. For
more information, please visit
http://www.provisionwealth.com
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