Today’s tax law puts your income and deductions into three separate buckets for tax purposes. Each bucket has its own rules and regulations. These are the three buckets: active, passive and portfolio.
A real estate rental is automatically in the passive bucket if you do not qualify as a real estate professional. This bucket has a lid on it that limits rental property loss deductions against anything other than passive income. This is not a good bucket.
If you own rental real estate, you can generate deductions of tens of thousands of dollars to offset other income as long as you avoid the passive loss bucket by:
Test 1. qualifying as a real estate professional, and
Test 2. materially participating in the rentals.
Test 1: Real Estate Professional
To claim status as a tax law–defined real estate professional (step 1 above) who can deduct his or her rental property losses, your time record for the year must prove:
1. you OR your spouse individually work more than 750 hours, and
2. that more-than-750-hour-work effort by you OR your spouse individually is more than half of that individual’s total work effort for the year.
Either you or your spouse must individually qualify as a real estate professional. If one spouse qualifies, both spouses qualify.
Test 2: Material Participation
Achieving real estate professional status is the first of two steps. You face one additional hurdle. To deduct tax losses on a rental, you also must prove that you materially participated in the rental activity. If you are married, you and your spouse may count your joint efforts toward passing the material participation tests.
Most of the tests for material participation are based on hours worked.
What Does This Mean to You?
In simple terms: keep a time log.
In an audit of your real estate activity, the IRS tells its examiner:
Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Reg. Section 1.469-5T(f)(4) to provide proof of services performed and [of] the hours attributable to those services.
In conclusion, if you don’t have what the IRS wants, your odds of winning your rental property tax loss deductions are slim, if that. And don’t think you can create this log after the fact. Most everyone who spends the considerable time it takes to jump through the hoops to create an after-the-fact log of hours using the IRS spreadsheets loses the deductions.
We specialize in helping clients get this right in advance so they keep more of their money. Many small business owners who come to see us in Fort Worth, TX generally do not understand the tax laws and may find themselves in trouble with the IRS.