In general real estate activity is considered a passive activity which means that any loss is not deductible in the current year and must be carried forward.
There are two exceptions to this rule:
1. Taxpayers can deduct up to a $25,000 special loss allowance if they actively participated the the rental activity and their modified AGI is below the limit, or
2. Taxpayers can deduct the full amount of loss if they are a real estate professional.
How do you qualify as a real estate professional? The tax court answers this in Sezonov v. Commissioner, T.C. Memo. 2022-40.
Real estate professional and material participation
Section 469 disallows a deduction for “passive activity loss.”
Section 469 has an exception for the rental activities of taxpayers engaged in a real property trade or business, i.e., real estate professionals.
If a taxpayer qualifies as a real estate professional, then the rental activity is treated as a trade or business, and losses are fully allowed.
To qualify as a real estate professional, the taxpayer must meet the material participation test in section 469.
There are two requirements for material participation in which the taxpayer must show that:
- more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates AND
- such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
The first requirement requires that at if the taxpayer is engaged in another trade or business, he must spend more than that amount of time on the real estate activity.
Example: John is employed as an part-time engineer working 25 hours a week. He also owns and manages an apartment complex on which he spends 20 hours a week. Since he does not spend more than 25 hours, he would not qualify the first prong of the test.
Recordkeeping can be provided by any “reasonable means” which include the approximate number of hours spent substantiated by appointment books, calendars, or narrative summaries.
Court’s findings
In this tax court case, the taxpayers provided time logs that showed that they spent a combined 476 hours on managing their Florida rental properties. However, this fell short of the required 750 hours.
They also failed the other requirement for material participation because the taxpayer did not spend more time working in the real estate rental business than in his HVAC business in either year.
Accordingly the tax court held in favor of the IRS and disallowed the passive activity losses.
The takeaway
Taxpayers who wish to claim rental property losses under the real estate professional exception should carefully review material participation rules and keep good records to substantiate their time involvement with their rental properties.