Real estate is top of mind when it comes to businesses that create passive income streams or losses. Ownership in other types of companies can also create passive income. Investments also produce passive income and losses. Understanding passive income streams and how to account for them is vital to creating tax planning strategies. A real estate CPA will analyze each of your activities to determine whether it is passive or nonpassive before embarking on creating an overall tax plan.
Passive activity rules are a set of regulations released by the Treasury intended to limit the allowance of losses from certain activities in which taxpayers don’t sufficiently participate against other types of income. To understand these rules, it’s important to know what activities the IRS constitutes as “passive income.”
Understanding Passive Income: Passive versus Nonpassive
Income or loss is considered passive where the taxpayer does not have a material role in the activity used to generate that income or loss. This lack of material participation is seen in activities such as trades, real estate and other rentals. Essentially, any business activity where you don’t materially participate constitutes a passive activity.
On the other hand, if you regularly and continuously participate in the day-to-day activities typical of an owner, then the income generated by the business is considered nonpassive.
The IRS has tests to determine material participation. Generally, if you participate more than five hundred hours in the activity, it’s nonpassive income. Other tests include where the taxpayer’s activity constitutes substantially all of the participation of all individuals, and where a taxpayer participates more than 100 hours during the year and not less than that of any other individual. Ensure you keep time reports, calendars or logs to establish how much time you have spent participating in the business. (Things get a little more complicated with rentals and accounting for real estate, but more on that in a minute.)
Depending on the underlying investment, some capital gains or losses can also be considered passive income. This is determined on a case-by-case basis, depending on the underlying investment.
Understanding the Passive Activity Loss Rules
If your venture is a passive activity, then the passive activity loss rules come into play. For one, these rules prohibit you from deducting losses that you generate from your passive income from the income you earn from materially participating activities or other nonpassive income streams. Nonpassive income includes: wages, annuities, dividends, interest, royalties, gas and oil royalties, and gains and losses from portfolio investment and nonpassive activities. However, as we said above, there are cases when you can classify your capital gains or losses as passive income. For instance, one of our clients had $200,000 in capital gains due to capital investment, and we were able to free up a number of losses in this case by applying the passive activity rules.
While these rules might limit your ability to deduct losses in any tax year, any losses you can’t use one year can be carried over to the next, indefinitely. Additionally, when you dispose of a passive activity, you are able to release all the suspended losses. For example, say you own rental real estate with suspended losses going back several years. When you sell that property, you can release the suspended losses related to that property – no matter what. You can then deduct these suspended losses against other nonpassive income.
Accounting for Real Estate: The Rental Activities Exceptions
When it comes to rental real estate activities, all rental income is generally categorized as passive income, no matter how much you participate.
So, even if you materially participate in running your rental properties, you still can’t deduct those losses against other nonpassive income. That is, unless you meet one of the following exceptions:
- You can deduct up to $25,000 of losses from rental real estate activities (even though they’re passive) against earned income, interest, dividends, etc., if you “actively participate” in the activities (requiring less participation than “material participation”) and if your adjusted gross income doesn’t exceed specified levels.
- If you’re a qualified real estate professional, then your rental activities aren’t immediately considered passive. To be regarded as a real estate professional, you must perform a substantial amount of real estate business, defined as more than half of your time, and at least 750 hours, spent in real estate trades or businesses. (Please note – this is a federal rule. California doesn’t conform to the laws regarding real estate professional designation).
Need help with your passive income?
If you participate in any passive income activity, either directly or through “pass-through” entities, these passive activity loss rules probably apply. We’re experts in tax planning and strategies for real estate businesses and navigating the passive activity rules.
If you want to ensure you’re structuring your activities in the best possible manner or you want to learn more about how these rules might apply to your business, contact our real estate CPAs today.