How Real Estate Tax Law Can Help – or Hurt – Your Bottom Line
If you’re in the real estate business as a broker and own rental properties, there are critical real estate tax law stipulations that impact your tax posture.
Most importantly, how much time and money you spend on rental properties, and how those activities are categorized will influence whether or not you can take deductions on your tax returns – and how large those deductions can be.
Your 2 Goals: Establish Yourself as a Real Estate Professional for Tax Purposes, and “Materially Participate” in Rental Properties
When the Tax Cuts and Jobs (TCJA) Act was signed into law in December 2017, the real estate industry reacted positively.
According to Section 199A, real estate agents operating as “pass-through businesses” such as sole proprietors, partnerships, and S-corps could qualify for up to 20% in deductions on business-related income. Your goal is to ensure your rental property activities and investments qualify for these deductions.
The first step is to establish yourself as a “real estate professional” within the guidelines of real estate tax law.
If you do not qualify as a real estate professional in the eyes of real estate tax law, your rental properties are viewed as “passive income.” That means you can only deduct your losses against other passive income within the tax year (or if you sell the rental property).
In addition to qualifying as a real estate professional, you must also “materially participate” in the management of your rental property or properties. Now, we’ll explain how to meet both of these requirements.
First, there is one exception to real estate tax law you should know. Even if you are not a real estate professional and your annual income or salary is under $100,000, you can take up to $25,000 in losses. According to real estate tax law, that $25,000 phases out until you reach $150,000 in income. After that point, losses are deemed passive – unless you utilize the following practices.
Know Your Numbers: Qualifying as a Real Estate Professional and Material Participation
Real estate tax law is crystal clear on the thresholds you must meet to avoid your rental property losses being labeled as “passive.”
You Qualify as a Real Estate Professional if:
- More than 50% of your personal services are in “real property trades or businesses” in which you materially participate; and
- You perform more than 750 hours of services during the taxable year in real property trades or business in which you materially participate.
The IRS real estate tax law defines “real property trade or business” as involvement in brokerage trade, leasing, management, operation, rental, conversion, acquisition, construction and reconstruction, and property development and redevelopment.
So how do these real estate tax laws relate to your rental property? And what does it mean to “materially participate” in your rental property? Let’s take a closer look…
Example: How a Broker Deducted Their Rental Property Losse
Real estate tax law outlines 7 different tests that a person must meet to be deemed as materially participating in rental properties. The more tests you can meet, the better, although you technically only need to meet one. You can view all 7 material participation tests, here. To be audit-proof, aim to meet the rules of these 2 tests as outlined in this example:
1) A broker worked 850 hours on real estate activities in 2018. She spent 700 hours on her brokerage business, 150 hours managing one rental property, and 50 hours on a second rental property. She has therefore spent more than 750 hours on real estate-related activities during the taxable year.
This broker does own another business, but she spent LESS than 850 on that other business. If she had spent 900 hours? She would not have met the real estate tax law requirement of spending MORE THAN 50% of her personal service time on a real estate-related business.
So, this broker has passed the first test according to these real estate tax laws. Now let’s look at the material participation requirements.
2) The broker wants to deduct her losses from managing her 2 rental properties.
Uh-oh! The IRS deems material participation as being more than 100 hours per rental property. She is ok on the first property (150 hours of participation), but she only spent 50 hours on the second. There is a legal workaround though! The broker can elect to treat the properties as one and so combine the losses from both of her 2 rental properties and treat them as one for tax purposes.
In fact, real estate tax law allows you to combine any number of rental properties to meet the material participation threshold of 750 hours.
The broker is therefore able to deduct her losses from both rental properties on her tax return.
By the Book: Why Bookkeeping and Detailed Records Matter (Plus a “Trick” to Deducting Business Travel)
Here at Robert P. Russo CPAs in New York City, we cannot stress enough how important it is that you keep impeccable records of your “material participation” and status as a real estate professional. Keep a timesheet so you can prove that you’ve spent more than 750 hours as required by real estate tax law.
From contractor work to lease management, maintain receipts and a calendar of activities. The IRS keeps close watch on brokers to make sure they’re following the real estate tax laws.
Pay special attention to travel to your rental property. In general, the IRS views travel from home to the rental property as a commute. However, if you establish a home-based office (by actively deducting a percentage of your utilities and the mortgage for office space), the travel expenses may be deductible as a loss.
If your property is 30 miles away and you travel there once a week, that’s 60 miles a week. That travel becomes deductible according to real estate tax law!
Many real estate court cases are lost because the broker doesn’t properly track their time and expenses. The IRS is looking at minutes, not hours. Tracking your time down to the minute is essential. Are you on the phone with a tenant for 15 minutes discussing an issue? Track it. Are you shopping online for new fixtures at your property for 45 minutes? Track it and record it.
Ultimately, real estate tax law can work in your favor if you follow the rules – and can prove that you did so. Owning a rental property is a great way to both reduce your tax liability and gain income.
At Robert P. Russo CPAs, we work with dozens of brokers and other real estate professionals. We help them maximize their tax deductions, and minimize their tax risk. If you have questions related to real estate tax law, contact us today.