Debits & Credits
by Douglas Schultz & Alexander Yarmolinsky
Q. My wife and I own an apartment building. My wife spends approximately 300 hours a year managing and administering the building. The building generates a $20,000 loss. In addition, my wife spends 1,000 hours a year as an employee for a mortgage-brokerage firm where she earns $50,000 a year. I work as a real-estate broker and spend 1,200 hours a year selling houses, and I make $50,000. Can we use the rental losses to offset our other earned income?
A. Yes. Under Internal Revenue Service (IRS) Code Section 469(c)(7), taxpayers who are considered real-estate professionals can treat rental losses (normally not deductible due to passive-loss limitations), as nonpassive losses.
Generally, losses generated by rental real estate are considered passive losses. Passive losses cannot be used to offset other types of income such as earned income, which is considered nonpassive.
Fortunately, this particular IRS code provides special relief provisions for real-estate professionals to characterize rental losses as nonpassive losses rather than passive losses. In order to qualify as a real-estate professional, a taxpayer—in any given tax year—must perform more than 750 hours of personal services (and more than half of their total personal-service hours for the year) in a real-property trade or business in which they materially participate. (To materially participate is to be actively involved in the management of the rental property.) For married taxpayers, the participation of one spouse is treated as participation by the other spouse for the purpose of determining if the second spouse materially participates in the activity.
In the above example, the landlord spends more than 750 hours (and more than half of his total working hours for the year) in a real-property trade or business in which he materially participates. Although the landlord, in the above example, does not materially participate in the management of the properties, he is allowed to take into account his wife's participation in the rental properties. Consequently, together they materially participate in the management of the building and can take the $20,000 loss as a nonpassive loss.
Please note that the wife's participation as an employee for the mortgage-brokerage firm is not taken into account since she is not at least a 5% owner of that business. As a result, she would not be able to recognize the loss based solely on her participation at the mortgage broker firm.
In addition, California has not conformed to the rules outlined in this IRS code 469(c)(7). The losses would be considered passive and not deductible for California purposes.
Q. I own three rental properties. I spend at least 350 hours a year managing property A, 100 hours a year managing property B, and 75 hours a year managing property C. The properties generate losses of $25,000, $10,000 and $5,000 respectively. I spend 1,200 hours per year working as a computer consultant, netting $75,000 of income. Can I use the losses generated by my rental properties to offset my income as a computer consultant?
A. Yes. Those who are not real-estate professionals can characterize losses as nonpassive if they materially participate in an activity, deduct up to $25,000 in losses against other nonpassive income, and earn an annual income of less than $125,000.
Taxpayers who materially participate in an activity can characterize their participation as nonpassive. In order to materially participate in an activity, a taxpayer must spend more than 500 hours for a particular activity. In our example above, the landlord is not materially participating in any one of the rentals. However, for participation purposes, the regulations under IRS code 469(c)(7)(A) permit an election to treat all rental real-estate activities (including those held as limited-partnership interests) as a single activity, regardless of how the activities were treated in prior years. Thus, the landlord in this example is materially participating in an activity and can characterize his losses as nonpassive.
A good understanding of the passive-loss rules can ensure full recognition of rental losses and result in significant tax savings to landlords. However, the passive-loss rules can be quite complex, and it is recommended that rental owners consult with a tax advisor to determine if passive-loss rules can be applied to their specific situation.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Doug Schultz is a CPA and partner in the tax practice at Burr, Pilger and Mayer. Alex Yarmolinsky is a CPA and a manager in the tax practice at Burr, Pilger and Mayer. Both can be contacted at 415-421-5757. Copyright © 2005 by the San Francisco Apartment Magazine. All rights reserved.