December 6, 2022
Real estate can be a great source of supplemental income while simultaneously building wealth. There is no shortage of tax law surrounding real estate. It can be very intricate and complicated to navigate. In general, there are three general categories that a taxpayer falls under when it comes to the level of participation in rental real estate activities. Each participation category results in a different set of rules and tax treatment. Below is a high-level general summary of each real estate participation category starting from lowest standard to the highest.
1. Passive Participation
This type of categorization is the default standard. It means you have a passive stake in a rental income producing real estate property. Features of this real estate categorization include:
- Low level of participation and control in real estate investment.
- Inability to deduct passive losses in excess of passive income. In other words, you can only deduct passive losses up to the amount that you have offsetting passive income. Passive losses not recognized are suspended to be used in future tax periods.
- Income and gains are subject to net investment income tax of 3.8% for those taxpayers exceeding certain income thresholds provided by the IRS.
- Previously suspended passive losses are realized upon sale or disposition of ownership in real estate investment.
- Losses from a result of disposition/sale of real estate are treated as capital losses.
2. Active Participation
This categorization falls somewhere between passive and real estate professional/material participating. It’s a higher standard to meet than passive treatment but a lower standard to meet than real estate professional treatment. It’s more commonly applicable to individuals. The features of active participation are similar to those of passive. The primary differences are that there is a slightly higher level of participation required and taxpayers are provided a special allowance for passive losses.
- A taxpayer is considered active if they meet the following criteria:
- Own at least 10% of the rental property.
- Make management decisions in a significant and bona fide sense. Examples of management decisions include new tenant approvals, deciding rental terms, and approving expenditures.
- May still qualify even if you use a management company.
- You cannot be a limited partner.
- Provides a special allowance for taxpayers to realize passive losses (without the need for offsetting passive income) of up to $12,500 for single filers and $25,000 for married filing jointly filers
- Income phase-out thresholds do apply.
3. Real Estate Professional
This is the most stringent standard to meet being that it provides taxpayers with the most tax-favorable treatment. Before the IRS grants you the most preferred tax treatment when it comes to real estate, they’re going to require you to clear a few hurdles first. This is where the tax law starts to become very nuanced. We’ve included some of those details here within but below provides general features of the real estate professional categorization.
- To qualify as a real estate professional, a taxpayer must:
- Perform more than 50% of their personal services and spend more than 750 hours during the year in real property trades or businesses in which they materially participate.
- Meet one of the seven material participation tests set by the IRS
- There is no limit on the amount of rental real estate losses that can be deducted on the taxpayer’s tax return.
- Income and gains are not subject to net investment income tax of 3.8% for those taxpayers exceeding certain income thresholds provided by the IRS.
- Losses from a result of disposition/sale of real estate are treated as ordinary losses.
If you think you may qualify to be classified as real estate professional or have other questions regarding real estate participation, please contact your tax professional. Feel free to schedule a consultation with us.