Most rental real estate activities are treated as passive activities under IRS rules. As a result, rental losses may be limited and not fully deductible against other types of income. However, taxpayers who qualify as a Real Estate Professional may be able to treat their rental activities as nonpassive if they also materially participate in those activities. This can allow rental losses to offset other income, subject to IRS rules.
According to the IRS Schedule E instructions, you must meet both of the following requirements during the tax year:
- More than half of the personal services you perform in all trades or businesses during the year must be performed in real property trades or businesses in which you materially participate.
- You must perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate.
You must satisfy both tests every year that you claim Real Estate Professional status.
What Is a Real Property Trade or Business?
Real property trades or businesses generally include activities involving:
- Real estate development
- Construction or reconstruction
- Acquisition of real property
- Conversion of property
- Rental and leasing activities
- Property management
- Real estate brokerage
Only qualifying services performed in these activities count toward the Real Estate Professional tests.
What Does Material Participation Mean?
Meeting the Real Estate Professional tests alone is not enough. You must also materially participate in the real estate activities. Material participation generally means you are involved in the operation of the activity on a regular, continuous, and substantial basis. The IRS uses several tests to determine whether material participation exists. Because the rules can be complex, it's important to maintain records showing:
- Hours worked
- Tasks performed
- Dates of participation
- Property management activities
- Tenant and contractor communications
Good records can help support your position if the IRS requests documentation.
Do I Have to Qualify Every Year?
Yes. Real Estate Professional status is determined on a year-by-year basis. Even if you qualified in a prior year, you must meet both the more-than-half-of-services test and the 750-hour test again for the current tax year.
If you do not meet the requirements in a later year, your rental activities may once again be subject to the passive activity loss rules.
What About Multiple Rental Properties?
If you own more than one rental property, special rules may allow you to elect to treat your rental real estate interests as a single activity for purposes of determining material participation.
Without such an election, material participation may need to be evaluated separately for each activity.
Because this election can significantly affect how losses are treated, taxpayers with multiple rental properties should carefully review the applicable IRS rules before making the election.
Why Does Real Estate Professional Status Matter?
Qualifying as a Real Estate Professional can provide valuable tax benefits.
If you qualify and materially participate in your rental activities:
- Rental losses may not be subject to the normal passive activity loss limitations.
- Losses may be used to offset wages, self-employment income, and other nonpassive income.
- Suspended passive losses may be reduced or eliminated.
This can be especially beneficial for taxpayers who spend substantial time managing rental properties and incur significant rental losses.