Do you own investment real estate—say, an apartment building—that you rent out to tenants? Real estate can be a valuable and reliable source of income. Of course, the rental income is subject to tax, but the resulting tax liability may be offset by deductible expenses. In some cases, you might even qualify for a loss.
However, there is another wrinkle in the tax law. The loss may be disallowed under the passive activity loss (PAL) rules.
Background: Generally, losses from passive activities can only offset income earned from other passive activities. Any excess passive loss for the current year may be carried over indefinitely to future years.
For this purpose, a passive activity is an undertaking involving the conduct of a trade or business in which you do not “materially participate.” That means you don’t participate in the business on a regular, continuous and substantial basis. The IRS has issued regulations detailing the requirements for this status. For example, you are considered to be a material participant if you work more than 500 hours a year at the activity.
A real estate rental activity is automatically treated as a passive activity. However, under a special tax law provision, an “active participant” in rental real estate may be able to use up to $25,000 of loss to offset nonpassive income. This exception is phased out for investors with an annual adjusted gross income (AGI) between $100,000 and $150,000. The tax benefit disappears completely if your AGI equals or exceeds $150,000.
Note that the “active participation” test is more stringent than the “material participation” test. The participation must be significant and legitimate. For instance, you might make management decisions, approve new tenants, arrange for repairs and so on. But simply listing yourself as a real estate manager or rental agent is not enough.
Add another complication to the tax equation. Under rules that went into effect in 2013, a 3.8% Medicare surtax applies to the lesser of net investment income (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. The definition of NII covers many income items, such as capital gains, dividends, interest and the like. Significantly, NII also includes income from a passive activity.
One possible way to avoid an adverse tax outcome is to increase your level of participation in order to qualify as a “real estate professional.” Typically, to satisfy this test, you have to spend more than 750 hours and more than half of your working time on the activity during the year. Depending on your circumstances, it may be well worth the extra effort.
Alternatively, you might invest in passive income generators (PIGs) at the end of the year. By creating more passive income through a PIG, you can absorb a passive activity loss.
Finally, analyze your situation with your tax advisers. Then develop a plan that takes all the economic and tax implications into account.