Real estate tax can be complicated. Unfortunately, there are a few things about the way the IRS categorizes income and losses that don’t make logical sense. And that’s where do-it-yourself real estate investors can get in trouble if they’re also trying to DIY on their business structures and tax plans.
One of the fundamental issues with real estate is that your income and losses could be considered:
- Trade or business,
- Passive Income/Loss with Active Participation,
- Passive Income/Loss with Material Participation or
- Strictly Passive Income/Loss.
If your real estate income/loss is trade or business, you’re most likely considered a real estate dealer. That means income will be subject to self-employment tax if you’re in the wrong business structure. Typically a real estate dealer is involved in flipping, wholesaling or just generally buying properties to resell for profit (hopefully). If there is a loss, then the full amount of the loss is allowed as a loss against other active income.
If you have real estate that you hold for rental and you have a loss, you have a passive loss. If you make less then $100,000 in adjusted gross income, and you actively participate in the business you can offset up to $25,000 of the loss against other income.
If you make more then $100K, you will need to materially participate plus qualify as a real estate professional to get the full loss offset against other income.
Otherwise, your loss is strictly a passive loss and can only go against passive income.
In a recent case, a real estate investor had been holding property as rentals. He bought a few properties that didn’t fit as rentals and so he decided to sell. He claimed that the gain on these sales would be the same as the losses on other properties. It was all ‘one business.’ The IRS disagreed. And the owner disagreed with the IRS, so it was up to the Tax Court to sort it out.
The Tax Court agreed with the owner. Normally, gain from property that was bought simply for resell could not offset passive loss from rentals. But the intent of the investor was to hold it as rentals. He just changed his mind. And the Tax Court said he could.
This is an important ruling for a couple of reasons. One, the intent turned out to be more important than the strict facts of the case. Second, and this is important for anyone who wants to use this case to back-up their tax facts, make sure you have good documentation of what you’re doing and why.
Are you sure your tax strategy is up to date with the latest tax rulings? Our USTaxAid Services CPAs keep up to date on the latest in tax strategies, tax court rulings and other important tax considerations for real estate investors and others.