How to deduct unlimited real estate losses against other income while avoiding the pitfalls of tax laws.

Much of this post was originally posted in the San Francisco Business Times in December 2008

Qualifying and claiming the Real Estate Professional Tax Status allows passive losses to be deductible against ordinary income on tax returns without limits, dramatically lowering tax bills. Moskowitz LLP is a one-stop shop for tax services, not only providing Advisory Tax Services, Tax Accounting, and Tax Return preparation, but also defending taxpayers in tax disputes (like an IRS tax audit). We are therefore in the unique position to see the common pitfalls of law that taxpayers face when deducting real estate losses against ordinary income because taxpayers who deduct real estate losses against ordinary income are often audited by the Internal Revenue Service.

The Internal Revenue Code places constraints on netting real estate loss against income from other sources. As a general rule, a taxpayer cannot offset passive losses against wage, interest, or dividend income. The rental of real estate is generally a passive activity. However, Congress has promulgated special tax laws for passive losses associated with real estate rental income. Federal tax law provides that up to $25,000 of losses associated with real estate rental activities can be netted against ordinary income.

The key to claiming real estate losses from rental property is to qualify by actively participating in rental activity. Active participation standards are met if you own at least ten percent of the rental property and have substantial involvement in managing the rental (defined as you spending more than 500 hours at the activity and no one else spending more hours in that particular real estate activity than you). If you are a limited partner in the real estate rental activity, you will not qualify for the deduction. The $25,000 special loss allowance is phased out by fifty percent if your modified gross income exceeds $100,000. It reaches zero by the time your income hits $150,000.

The ideal scenario may be to take unlimited losses against ordinary income. For tax purposes, people who meet eligibility requirements are able to deduct against ordinary income (wages, dividends, interest, etc) real estate losses in unlimited amounts, a departure from the general rules.

To qualify for this unlimited tax deduction a taxpayer must meet the tax requirement for “real estate professional.” Which, for tax purposes, qualifying as a “real estate professional” means that either you or your spouse:

  • Must materially participate in the rental real estate activities. Basically, a taxpayer is considered to materially participate when involvement in the activity is regular, continuous, and substantial.
  • More than fifty percent of your time spent working during a calendar materially participate.
  • Must spend more than 750 hours of service during a calendar year performing real estate rental activities.

It is extremely important that you keep a timely log of all activities performed in real estate. The IRS will likely challenge logs prepared after the fact with “ballpark” estimates. Therefore, detailed logs are extremely important to substantiate your participation in the real estate rental market to the IRS in the event of an audit.

Common Pitfalls when deducting real estate losses against ordinary income

Besides good bookkeeping and time records demonstrating the time spend participating in rental real estate activities, some common problems taxpayers face when defending their real estate professional tax status when they have offset ordinary income with real estate losses are:

  • Taxpayer is employed full time elsewhere. The Courts often side with the Internal Revenue Service when the taxpayer has claimed the Real Estate Professional Tax Status but is elsewhere employed as 750 hours per year would require an average of 14.4 hours per week spend on the activity.
  • This being said, we often see situations where one spouse is employed and it is the spouse who is spending the time in the real estate investments. Where qualified it is acceptable to offset the employee spouse’s wages and classify the other spouse as a real estate professional.
  • Relying on Education and research hours to meet the 750 hour test. These hours are not considered personal service hours.

Moskowitz LLP – Tax Services for Real Estate Investors

We believe that most individuals and small businesses pay more than their fair share of taxes because they don’t have a team of accountants and attorneys to help them navigate complex tax codes and limit their tax liability. We are that team.

Our Tax Law, Tax Accounting and Advisory Services for Real Estate Investors include:

  • Rental Property Tax Optimization
  • Rental Losses Analysis and Optimization
  • Real Estate Tax Credit Analysis and Implementation
  • High Net Worth Strategies
  • Entity Structuring Strategies and Compliance
  • Contracts and Agreements
  • Tax Planning, Tax and Accounting Updates
  • Civil/Criminal Tax Law Defense

Have Questions? Want to see what Moskowtiz LLP can do for your business? Contact Us