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Own a Rental Home? Passive Activity Taxation Rules May Apply to You

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Passive activity is an IRS term for business activities in which one does not materially participate.  Regardless of material participation in the management of rental property, however, the IRS considers the activity passive.

Why is this important?  If a taxpayer owns real property that is rented, the passive activity limitations apply.  Generally, a loss from a passive activity is not deductible unless income from another passive activity exists to offset it.  The good news?  Excess losses can be carried forward to future years, until the sale or disposition of the property.

As with most topics in the Internal Revenue Code, there are always some exceptions.  The main exception is the $25,000 special allowance.  If a taxpayer actively participates in managing the rental property, he or she is allowed to claim up to $25,000 of losses if adjusted gross income is below $100,000.  Losses are completely disallowed once income is $150,000 or more.  This phase-out applies to taxpayers filing single or married filing jointly.

The other exception for claiming passive activity losses applies when a taxpayer qualifies as a real estate professional.   Taxpayers who claim the real estate professional exemption should be aware that it may result in an audit, as the requirements are stringent. To meet the qualification, real estate professionals must spend more time on real property business than any other work, and, must perform more than 750 hours in real property trades or businesses in which they are an owner.  These qualifications are high hurdles for those who have a job outside of being a landlord.

Of course, if a taxpayer actually qualifies as a real estate professional, they should claim the losses to which they are entitled.  The key is being willing and able to prove both requirements.  Last year, a Tax Court case ruled in favor of the IRS.  The taxpayer claimed 1,942 hours spent in one year managing her rental properties.  Since she also worked 1,650 hours at her other job, the Tax Court concluded that she would have had to spend almost all of her remaining time working on the rentals, and thus concluded that was not likely.

As with most tax issues, keeping meticulous records is critical to claiming losses.  Maximum tax efficiency can be achieved with proper planning.  Consult with a Certified Financial Planner™ professional and your tax advisor for solutions to fit your individualized situation.

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