A growing number of real estate agents, brokers and investors may come under IRS scrutiny concerning losses used to offset ordinary income. Those who are unable to prove that they meet the definition of a real estate professional under the Internal Revenue Code are classified as passive real estate investors and prohibited from deducting their job-related losses, including depreciation as well as office and travel expenses, in full.
First, we should begin by explaining the three types of income.
Active Income Includes:
- Wages, salary, commissions, bonuses and other payments for services rendered by the taxpayer;
- Profit from a trade or business in which the taxpayer materially participates;
- Gain on the sale or other disposition of assets used in an active trade or business, and
- Income from intangible property if the taxpayer’s personal efforts significantly contributed to the creation of the property.
Portfolio Income Includes:
- Interest, dividends, annuities and royalties not derived in the ordinary course of a trade or business, and
- Gain or loss from the disposition of property that produces portfolio income or is held for investment purposes.
Passive Income Includes:
- Any trade, business or income-producing activity in which the taxpayer does not materially participate, and
- All rental activities, subject to certain exceptions, whether the taxpayer materially participates or not.
Losses from passive activities can only be deducted against income from passive activities. One exception to this rule is that the first $25,000 of passive losses from rental activities can be deducted if you actively participated in the rental activities. The maximum special allowance is reduced if your modified adjusted gross income exceeds certain amounts.
There is also an exception to the passive activity rules if you are a qualified real estate professional. You are considered a real estate professional if, during the year, the time you spent performing services in real property trades or businesses in which you materially participated was:
- More than half of the time you spent performing personal services in all trades or businesses, and
- More than 750 hours.
A real property trade or business is one that develops, redevelops, constructs, reconstructs, acquires, converts, rents, operates, manages, leases or sells real property. Appointment books, calendars, and narrative statements can be used to prove material presentation, and daily time reports and logs may be helpful as well.
If you qualify as a real estate professional, the rental real estate activities in which you materially participated during the year are not passive activities. They can be classified as non-passive income or losses and used to offset ordinary income.
If you have any questions about classification as a Real Estate Professional, please contact Henssler Financial’s Tax Experts at 770-429-9166 or [email protected]..