Today’s Real Estate Word of the Month is “passive activity loss.” Not all losses are deductible for income tax purposes, especially in the real estate context. It is important for individuals with real estate rental income to understand the limitations on deductibility of losses arising from real estate rental activities.
For income tax purposes, a loss is an expense that may be deducted from income such as compensation, interest or dividends. An individual may deduct a loss incurred in a trade or business, a loss incurred in any transaction entered into for profit (even though the transaction is not related to a trade or business), and losses resulting from fire or other casualty. There are many other types of deductible losses. But for today’s purposes, we are focusing on passive activity losses.
Unlike “normal” losses, a passive activity loss may only be used to offset income from passive activities. A passive activity is a trade or business in which an individual does not materially participate. An individual is considered to “materially participate” if he or she (1) participates in the activity for more than 500 hours during the year or (2) if, under all the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during the year. With one exception, real estate rental activity is per se a passive activity no matter whether the individual materially participates in the rental activity.
The exception is for individuals who are “real estate professionals.” An individual qualifies as a real estate professional in a given year if more than half of the personal services that he or she performs during that year are performed in real property trades or businesses in which he or she materially participates but in any event no less than 750 hours. For joint returns, the real estate activities of spouses cannot be combined. Rather, at least one of the spouses must qualify as a “real estate professional” in order to claim the exception.
For those individuals with losses from rental activities, it is important to keep complete timesheets, calendars, appointment books and other contemporaneous records that document one’s “material participation” in the real estate business.
Take the recent 2014 case of Mr. and Ms. Adeyemo, a husband and wife who managed seven rental properties. Both Mr. and Ms. Adeyemo had day jobs in the pharmaceutical industry. Mr. Adeyemo performed the bulk of the couple’s real estate management activities: maintenance and repairs, advertising and showing properties to prospective tenants, collecting rent and occasionally bringing eviction actions against tenants. In 2008 and 2009, the Adeyemos did not treat their losses from Mr. Adeyemo’s activities as passive activity losses. As a result, the IRS sought from the Adeyemos a deficiency of $39,157 (with penalties) for 2008 and a deficiency of $39,359 for 2009.
The Adeyemos were able to produce contemporaneous records showing that Mr. Adeyemo performed 1,500 hours of personal services in his pharmaceutical day job in 2008 and 800 hours of real estate activities. Thus, for 2008, of Mr. Adeymo’s 2,300 total hours of personal service, only 35% involved the real estate rental activities. The Adeyemos were also able to produce contemporaneous records showing that Mr. Adeyemo put in only 715 hours of service into the rental real estate in 2009, 35 hours less than the required 750. At trial before the Tax Court, the Adeyemos argued unsuccessfully that their contemporaneous records were not a complete re-telling of Mr. Adeyemo’s rental activities. To support their argument, the Adeyemos introduced a spreadsheet that they had created in preparation for trial, which the trial court characterized as an unreliable and uncorroborated “ballpark guesstimate” of Mr. Adeyemo’s activities three or four years past. In short, the Tax Court agreed with the IRS that the Adeyemos did not qualify as real estate professionals for purposes of deducting losses from their real estate rental activities.
The Adeyemos’ case demonstrates that it is critical for individuals who supplement their income with rental real estate to substantiate their real estate activities with contemporaneous timesheets, log books, calendars, receipts, appointment books and other records. Plus, with the introduction of the 3.8% net investment income tax in 2013, high-income individuals with rental real estate should be especially aware as to whether they meet the real estate professional requirements.
If you have any questions about how the information in this article may affect you or your business, please contact your Stroud attorney.
DISCLAIMER: The information in this article is provided for general informational purposes only, is not necessarily updated to account for changes in the law, and should not be considered tax or legal advice. This article is not intended to create, nor does the receipt of it constitute, an attorney-client relationship. You should consult with your own legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.