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How do the Passive Activity Rules Apply to Rental Real Estate?

January 09, 2015

Passive activities that apply to rentals could have a significant impact on your tax bill.

Much like the ordinary passive activity loss rules, it’s important to know how the passive loss rules apply to rentals, because it could have a significant impact on your tax bill. Passive income from rental activities is subject to the 3.8% net investment income tax.

Losses from passive rental activities generally can be deducted only from passive activity income. If you don’t have passive income from other passive activities, or your passive activity losses exceed such income, you’ll have to carry the unused losses forward until you have passive income to absorb them or you sell the investment.

In order to avoid passive treatment, as well as the 3.8% net investment income tax on passive rental activities, you must qualify as a real estate professional. In order to meet the real estate professional standard, you must provide more than one-half of your total personal services in real property trades or businesses in which you materially participate and perform more than 750 hours of services during the tax year in real property trades or businesses. Because the material participation portion of the test is applied to each real property trade or business, you may meet the overall 750 hours of services test during the tax year, but may not meet any of the seven tests provided in Reg. § 1.469-5T (a) for material participation for each real estate activity; and thus cannot qualify as a real estate professional. In this case, you should consider the grouping election, where all of your rental real estate activities are treated as one activity. This election makes it easier to satisfy the material participation standards and qualify as a real estate professional.

Keep in mind that the rules are complex and there are other tax and nontax factors to consider.

If you have real estate investments that might be subject to the passive activity rules, please contact us. We can help you sort through the complexities and determine the strategy that’s right for your particular situation.

Read our recent blog "Seven Tests to Qualifying Yourself as a Non-Passive Owner".

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