Get the Most From Your Passive-Losses

1. Overview

If you or your spouse is a landlord, a real estate broker, a property manager, a developer or in the construction business, your tax picture may have improved significantly starting in 1994.

For you, the Revenue Reconciliation Act of 1993 may have reversed the passive loss rules and limitations that came into existence with the Tax Reform Act of 1986. Under the former law, the passive loss rules limited deductions and credits from passive trade or business activities.

Deductions attributed to passive activities, to the extent they exceeded income from passive activities, generally could not be deducted against other income such as wages, portfolio income (interest, dividends, and so on), or business income that was not derived from a passive activity.

Credits from passive activities could not reduce the taxpayer’s tax liability, to the extent such credits exceed regular tax liability from passive activities.

Generally speaking, a passive activity is a trade or business in which the taxpayer does not materially participate. However, under pre-’93 Act law, rental activities were treated as passive without regard to material participation.

This was true regardless of how intensively or extensively the taxpayer may have participated in other non-rental real estate activities. For instance, if, under pre-’93 Act law, a taxpayer had $250,000 in net income from a real estate brokerage business in which he worked full-time and a $50,000 rental real estate 1066, he could not offset the rental loss against his income from the brokerage business or from any other non-passive source. Thus, under pre-’93 Act law, rental activities could not be treated as part of a larger activity that includes non-rental activities.

However, even under pre-’93 Act law, if an individual taxpayer satisfied an active participation test, he may have been able to offset up to $25,000 in non-passive income with losses and credits from rental real estate activities (even though they are considered passive).

This $25,000 amount was allowed for taxpayers with adjusted gross incomes of $100,000 or less, and is phased out for taxpayers with adjusted gross incomes between $100,000 and $150,000.

Active participation is a lesser standard of involvement than material participation. A taxpayer is treated as actively participating if, for example, he participates in a significant and bona fide sense in the making of management decisions or arranging for others to provide services (such as repairs).

The active participation standard is not satisfied, however, if the taxpayer’s interest is less than 10% (by value) of all interests in the activity. A taxpayer generally is deemed not to satisfy the active participation standard with respect to property he holds through a limited partnership interest.

The ’93 Act carved out an exception to the rule that provides all rental activities are treated as passive activities. With respect to qualifying taxpayers, for any tax year in which they qualify (i.e., if material participation is shown), the rental activity is classified as non-passive and any losses or credits generated by it may be used to offset the taxpayer’s other, non-passive income.

A qualifying taxpayer is anyone who performs more than half of their trade-or-business personal services and spends more than 750 hours a year in real property trades or business in which they materially participate.

Real property trades or businesses are broadly defined to include “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Personal services performed as an employee are not treated as performed in a real estate trade or business unless the person performing services has more than a 5% ownership interest in the employer.

A closely-held C corporation meets the eligibility requirements if more than 50% of its gross receipts for the taxable year are derived from real property trades ro businesses in which the corporation materially participates.

Being considered a “Real Estate Professional” does not automatically entitle a taxpayer to treat rental real estate losses as non-passive. The break merely provides that rental real estate activities are not automatically passive (as they were under pre-‘93 law).

To avoid the passive activity loss rules, the taxpayer must be a material participant with respect to real estate activity generating the loss. Material participation in a rental real estate activity exists if the owner participates more than 500 hours during the year or does substantially all the work in connection with the activity or meets certain other standards.

2. Examples

Example 1

John is a real estate broker. In 1993, he earned $250,000 in net commission income from his brokerage business and John was also a landlord who owned and operated, in a material way, several apartment buildings. His net income from rental in 1993 is a negative $50,000.

For 1993, even though John materially participated in both the brokerage and the rental operations, he was not able to use any of his $50,000 loss to offset his $250,000 income.

Presently, if John has the same commission income and the same rental loss, he is able to use all of his rental loss to offset his commission income! If John is in the 36% tax bracket, the current law will save him $18,000 in federal taxes.

Material participation is determined separately for each interest, unless the taxpayer elects to treat all of his or her interests as one activity.

Electing to treat all of a taxpayer’s rental real estate activities as a single activity may in certain cases make it easier to meet the material participation requirement by allowing the taxpayer to aggregate all of his participation in all such activities to satisfy, say, the more than 500 hours a year test.

To materially participate in an activity, a taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis. Except as provided in regulations, a taxpayer is treated as not materially participating in an activity held through a limited partnership interest.

Example 2

Barbara owns and manages a real estate brokerage business. She is also a limited partner in a partnership that owns a shopping center. Her annual share of the partnership’s income and expenses generates for her a tax loss of $10,000.

As a limited partner, Barbara is not considered to be a material participant in the shopping center partnership. For 1993 and the present, the partnership’s losses will be treated as passive in nature (i.e., the law does not change for her).

In the cast of a joint return, the more-than-half and more-than-750-hours requirements are met if and only if either spouse separately satisfies them. Thus, one of the spouses must separately satisfy both of those requirements without regard to services performed by the other spouse.

However, in determining material participation, no change has been made in the current rule under which the participation of the taxpayer’s spouse is taken into account in determining whether the taxpayer has met the material participation standard.

As a result, a husband and wife who file a joint return meet the more-than-half requirement if one of them performs more than half of his or her services in a real estate trade or business in which either spouse materially participates.

Example 3

Ed is a doctor who earned $200,000 in wages in 1993. Ed’s wife, Mary, is a real estate agent who earned $50,000 in commission income in 1993.

Ed and Mary own several apartment buildings. Mary is responsible for managing and taking care of the buildings. Ed and Mary had net income from rental operations in 1993 of a negative $50,000.

For 1993, even though Mary materially participated in both the brokerage and the rental operations, Ed and Mary were not able to use any of their $50,000 loss to offset their joint $250,000 income.

Presently, if Ed and Mary experience the same wage and commission income and the same rental loss, they will be able to use all of their rental loss to offset their wage and commission income. If Ed and Mary are in the 36% tax bracket, the current law will save them $18,000 in federal taxes.

If the taxpayer has suspended losses from a former passive activity (an activity that is not a passive activity for the current taxable year but was a passive activity for the taxable year in which the loss arose), the losses are offset against the income from such activity for the taxable year, and any excess after the offset continues to be treated as a loss from a passive activity.

Thus, such suspended losses are limited to income from the activity, and are not allowed to offset other income.

Deductions and credits that are suspended under these rules are carried forward and treated as deductions and credits from passive activities in the next year.

The suspended losses from a passive activity are allowed in full when the taxpayer disposes of his or her entire interest in the activity in a fully taxable transaction with an unrelated party.

In closing, it is important to note that the current law seeks to improve the tax picture of real estate investments by making changes in the areas of passive activity losses.

Investors who are not “Real Estate Professionals” and who will not benefit directly from the new law may still derive an indirect benefit from the current exception to the passive activity loss restrictions. This may take the form of increased values from rental real estate investments.

RealTax professionals have the knowledge and expertise to help you get the most from your passive-losses. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.