Let’s say you buy a vacation home and decide to rent the place. You incur a $4,500 loss for the year. You may think: What could be simpler than claiming this loss on my tax return?
However, in order to claim the loss on your tax return, you must “actively participate” in the activity. That’s easy to do since you approve the tenants, pay the taxes, and occasionally do maintenance or hire workers. Only the first $25,000 of such losses can be used to offset regular income. When your adjusted gross income (AGI) exceeds $100,000, that $25,000 exemption begins to phase out and is completely eliminated when your AGI reaches $150,000. Unused losses are deferred and can offset passive income or can be used when the property is sold.
Things can get much more complicated if you rent the property for an average seven days or less at a time. That’s often the case for beach or other vacation properties. The simple rules discussed above don’t apply to such rentals. In this case, it’s considered a trade or business and not a rental real estate activity.
And you can apply different rules if you manage a number of properties and can qualify as a “real estate professional.” But not only are there different sets of rules, the rules can interact as they did in one U.S. Tax Court case.
Facts of the case: Todd Bailey was a physician and his wife, Pamela, was well-versed in real estate. She did not earn a salary, but took care of several properties the couple owned jointly and she looked for others to purchase. One of the properties the couple owned was called The Inn on Alisal Road. There were two units, which were furnished and rented on a short-term basis to overnight lodgers, usually for three days at a time. The Baileys provided a coffee maker and coffee, but guests were responsible for their own meals. Pamela Bailey managed the Inn herself. Her onsite jobs included meeting potential guests, cleaning the interior, washing sheets, ironing, maintaining the exterior, watering, taking out the trash and cleaning the gutters. She also worked offsite making purchases for the property, doing banking, and other tasks. Her total time in the activity for the year was 324 hours.
The taxpayers had two other existing properties and a new addition. One of the properties had two units and Pamela Bailey spent a total of 358 hours during the year working there. A major portion of the time consisted of exterior maintenance, but a sewage backup and mold problem involved research and renovation. Activities associated with the third property consisted of bill paying and banking for 24 hours. The taxpayer spent 105 hours associated with the purchase of a fourth property including pre-offer research, discussions with a realtor and banker, and travel to the location. Finally, she spent a total of 192 hours researching other potential acquisitions.
The IRS allowed $20,683 of losses from the operation of the Inn. Since this was not a rental activity (average rental period was seven days or less), it was reported on Schedule C. The taxpayer was considered to have materially participated in the activity (total time 324 hours). There was a requirement to deduct the losses against ordinary income.
If you have employees, meeting the material participation can be difficult. Most likely, the taxpayer only had to show her participation was substantially all the participation in the activity of all individuals for the year, or more than 100 hours and at least as much as any other individual.
The losses from the rental properties were significant. Because of the extensive time spent working on the properties, the wife claimed to be a real estate professional and deducted the losses against ordinary income avoiding the passive loss limitation rules. To qualify as a real estate professional, a taxpayer must satisfy both of the following requirements:
1. More than one-half of the personal services performed in trades or business by the taxpayer during the year are performed in real property trades or businesses in which the taxpayer materially participates.
2. The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Many taxpayers fail the first test because they have a regular job or trade. For example, let’s say a taxpayer is an dentist in private practice. He performs 1,000 of hours of service in that activity and 900 hours managing rental properties. He doesn’t spend more than one-half of his time in the real property trade.
The second test may also be difficult to meet unless you’ve got several properties. And the test is done on a property-by-property basis unless you make an election to group the properties. While grouping generally makes sense, there are a number of factors to consider before making the election. Check with your tax adviser first.
Pamela Bailey didn’t qualify as a real estate professional because she didn’t meet the 750 hour requirement. She arrived at a total of 1,003 hours for participation in all her activities. Since she had no other trade or business, she clearly met the “more than one-half test.” But the court subtracted the 324 hours spent on the Inn, since it was not a real property trade or business. That left the taxpayer with only 679 hours, short of the more-than-750-hour requirement. The court disallowed the rental property losses. Instead they fell under the passive loss rules. (Bailey, T.C. Summary Opinion 2011-22)
Points to Keep in Mind
There have recently been a number of U.S. Tax Court cases involving the real estate professional rule, so it may have attracted IRS attention. Here are some points to keep in mind with respect to the rule:
- Spouses can’t combine their time. One spouse must meet the 750 hour requirement.
- You’ve got to be able to prove your participation. While you may be able to show that by several means, a contemporaneous diary could help prevail in an IRS challenge.
- If you’ve got more than one property, you’ve got to make an election to group the properties. Get good advice.
- You claim the losses on a separate line on Schedule E. That may make it an audit flag.
Keep in mind another important point in the Bailey case. Rental of property for an average period of seven days or less isn’t a real estate rental activity and doesn’t qualify under the $25,000 passive activity exception or under the real estate professional rules.
Renting real property can be very simple, but there are plenty of potential traps. And in many cases, the economics have changed. Losses may be more common than they were in the past. This is area you want to discuss with your tax advisor, particularly if you’re planning on buying rental property.
“When a taxpayer spends time on a real estate property that the taxpayer rents for periods averaging less than 7 days, that property is no longer a ‘rental activity.’ Therefore, the taxpayer must exclude or ‘disregard’ the time he or she spent on the property for purposes of counting hours for the 750-hour…test to be a real estate professional.”
— The U.S. Tax Court