The Passive Loss rules can seriously restrict the ability of real estate investors to deduct their real estate losses against other income. Additionally, the 3.8% Net Investment Income Tax (NIIT) includes income from these passive rental properties in the calculation of Net Investment Income. However, for a special class of taxpayers, Materially Participating Real Estate Professionals, real estate losses may be fully deductible and income from rental real estate may be exempt from the NIIT.
Who Is a Real Estate Professional?
Under the tax code, a taxpayer may qualify as a Real Estate Professional if:
- More than 50% of the personal services performed by the taxpayer in all trade or businesses during the tax year are performed in real property trades or business such as property development, construction, property management, or real estate brokerage; and
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or business in which the taxpayer materially participates.
Because Real Estate Professional status provides such a significant tax benefit, in many cases the IRS will challenge a taxpayer’s qualification under these rules. As such, it is extremely important for those wishing to claim this tax benefit to diligently maintain records of their real estate activities in general and of their participation in each rental activity.
Travel Time Counts
A recent Tax Court Summary Opinion not only demonstrates the importance of maintaining a contemporaneous log, but also indicates that the time spent by a taxpayer traveling to and from a location for the purpose of conducting rental business, or performing maintenance on the property, should be included in calculating the taxpayer’s participation in real estate activities. Taxpayers living in a busy metropolitan area, such as DC and its surrounding suburbs, are well acquainted with traffic. The travel necessary to accomplish any activity in this area can certainly represent a significant investment of time.
In the case of Richard S. Leyh and Ellen P. O’Neill v. Commissioner of Internal Revenue (TC Summary Opinion 2015-27), the tax court allowed the taxpayer, Ms. O’Neill, to include a reasonable estimate for travel to and from her home in Dipping Springs, Texas to Austin, Texas where her rental properties were located. When combined with the other time related to the operation of her rental business that the taxpayer had documented in a contemporaneously maintained log book, her total participation in the real estate business exceeded the 750 hour threshold and qualified her as a real estate professional. In this case, the Tax Court allowed the taxpayer to deduct $69,531 of rental losses that the IRS had disallowed during examination of the taxpayer’s 2010 income tax return.
What is the Lesson to Learn?
Perhaps the most significant lesson for other real estate investors to learn from this case is the importance of maintaining well documented logs to support their participation in their real estate business. In Leyh and O’Neill v. Commissioner, the Tax Court cited the detailed, contemporaneous log book maintained by the taxpayer as the significant factor supporting her status as a Materially Participating Real Estate Professional. Although the regulations provide that an individual’s participation in an activity may be established by any reasonable means, it is clear from the body of case law regarding this matter that a thorough and complete record such as a log book is the best evidence.
When maintaining a log book, you should document:
- A clear day-by-day explanation of the specific rental real estate activity being performed and the property it is related to;
- Notation of the time, date, location and duration of the activity being performed; and
- Documentation of travel time and distance, and any expenses incurred in performing the activity.
The rules regarding the treatment of passive losses, NIIT, and material participation are complicated and require careful planning, including potentially filing elections and grouping of various activities. The tax professionals at Thompson Greenspon are experienced at helping clients navigate the complicated rules related to the taxation of real estate activities in order to minimize income taxes and maximize return on investment. If you have questions regarding your rental property, please contact us to discuss how we may be of assistance.
About the Author:
Eric Fletcher, CPA
Eric Fletcher is a principal with Thompson Greenspon and has more than 19 years of public accounting experience as a tax professional. Throughout his career, Eric has focused on working with closely-held businesses and their owners, especially family-run enterprises. He has served clients in the construction, real estate, and professional services industries in addition to working with many affluent individuals and family groups. His expertise includes all aspects of tax and business planning including mergers and acquisitions, private equity, succession and estate planning, capital budgeting and investment analysis, as well as IRS representation.
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