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Copyright 1996, Marc S. Weissman Weiss & Weissman, San Francisco, California (650) 574-0362 To Contact us: email Phone/Fax/Mail |
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This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.
The Revenue Reconciliation Act of 1993 has a major impact on some real estate professionals who own rental or investment real estate.
Since 1986, the Passive Loss Rules limited the deductibility of losses from rental real estate. All real estate rental was classified as a passive activity. Passive losses are subject to stringent rules regarding deductibility.
Special rules allow deduction of up to $25,000 of real estate rental losses if other income is less than $100,000 (when the special allowance begins to phase out - it is eliminated when income exceeds $150,000).
Disallowed losses are carried forward to future years, until either the activity is terminated or passive gains are generated from that or another passive activity.
Now, life is more simple for some "real estate professionals."
Starting in 1994 rental real estate is no longer passive if a real estate professional meets the following qualifications:
Real estate fields are broadly defined to include brokerage, leasing, management, rental, construction, and development.
Fortunately, most real estate agents are Independent Contractors, and therefore qualify, but Congress specifically exempted from this Passive Loss exemption any real estate professional classified as an employee, unless he also owns the company for which he works.
Although the new rule is advantageous, there is a catch: Losses from prior years which have been suspended and carried forward are not usable in 1994, but must be carried forward until the property has been disposed.
For example, a qualifying real estate professional owns a rental unit which generates a Passive Loss of $10,000 per year since its purchase in 1990. His income is over $150,000, and he has been unable to use any of the losses; he has a cumulative $40,000 carry over of the suspended loss into 1994.
[Had his income been less, he would have been allowed to use the entire loss each year if he "actively participated" in the management of the property.]
In 1994, he is allowed a full deduction for his 1994 loss; however, he cannot use his $40,000 carryover until he sells that property or has profits from other passive activities (which under these new rules do NOT include rental real estate).
A part-time real estate professional who sells insurance for 2,000 hours per year and real estate for 800 hours per year is not eligible for the special exemption, as he does not spend more than 50% of his professional time in real estate.
The fact that his wife is also a part-time real estate professional for 700 hours per year does NOT help qualify for this exemption. One person must satisfy these rules, which will allow both spouses on a joint return to be exempt.
If his wife works 750 hours in real estate (and more than 50% of her professional time), she qualifies, and on their joint return losses from real estate rental activities will not be passive.
This allows a highly paid person who is not in the real estate field, but who owns rental properties with unusable losses to have his spouse become a part-time agent, working at least 750 hours per year. If the couple files a joint return, all the otherwise passive losses would become deductible.
This may cause an influx of people who become real estate agents just for the tax benefits!
The real estate professional must still be actively involved with the rental of the property to be exempted from the Passive Loss Rules. Therefore, a Limited Partnership interest will NOT qualify.
PASSIVE ACTIVITIES consist of all Limited Partnerships, all rental activities (with a partial special allowance for some real estate), and any other business in which the owner does not materially participate. Losses from these activities are deductible only against profits from a passive activity, or on disposition of that activity.
The disallowed portion of such losses is carried forward to the future to offset passive income from that, or any other activity.
At disposition of an activity, unused losses may be used as follows: If the activity is sold at a loss, all prior disallowed losses from that activity will be allowed.
[REAL ESTATE is granted a special exemption, with certain complex limitations, if you own at least 10% of the realty (not in a limited partnership) and participate in the management, and your income is below certain levels.]
The limitations apply to activities which meet a 3 factor definition: (1) an activity, (2) carrying on a trade or business, (3) in which the taxpayer does not materially participate. Each factor is extremely complex.
If an individual participates materially in an activity, there is no Congressional worry that the purpose is tax avoidance, and losses in such activities are fully deductible.
"MATERIAL PARTICIPATION" is the key. There are seven tests, satisfaction of any one qualifies as 'material participation.'
Substantially all of the work in the activity is by the taxpayer.
More than 100 hours per year and not less than any other person, including non-owners.
More than 100 hours per year in each of several activities, totaling more than 500 hours per year in all such activities.
Material participation in that activity for five of any of the last ten prior tax years.
If the activity is a personal service activity, material participation in any three prior years.
Other facts and circumstances.
Spouses' participation is added together, as if one did all the work.
Document your participation in real estate to prove that the passive loss rules do not apply.
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