Passive Activity Rules May Limit Ability to Deduct Certain Losses

One of the collateral effects of the housing market crash and credit crunch has been the increase in rental real estate activity. Consumers who previously would have bought a home following a move are unable to secure mortgage, forcing them to rent. Additionally, more homeowners are renting the houses they leave behind following a relocation, unable to sell because they owe more than the current selling price. As a result, the tax rules regarding passive activities, including rental businesses, have become relevant for an expanding number of taxpayers.

The Internal Revenue Service includes, within the realm of passive activities, two major groups: business ventures in which the taxpayer does not participate in a material manner on a “regular, continuous, and substantial basis,” or rental businesses, including both rental equipment and rental real estate, regardless of the level of participation. Some real estate rental businesses may avoid the passive activity designation, if the taxpayer materially participated and participated in his/her capacity as a real estate professional. To qualify as a real estate professional, your material participation in your real estate rental business must comprise at least 51% of the total personal services you performed in all trades or businesses during that year, or you must perform in excess of 750 hours materially participating in your rental real estate business.

In general, if the losses from your passive activities total more than the income you received from the activity, you cannot deduct those losses in the current tax year. The losses are not “lost” to you, though. Rather, you must carry those losses over to the next year and, if your passive business makes money that year, the Tax Code permits you to offset that income with the losses you carried forward from the previous year. You can only carry losses forward, not backward.

In some cases, you may not need to wait until a future year to receive the tax benefits of your passive activity loss. If your activity is rental real estate, and you materially participated in the business (even though you were not a real estate professional,) the IRS creates a special allowance of up to $25,000 of losses that you may deduct from you current year’s return. The size of your maximum permissible allowance depends on your modified adjusted gross income (MAGI). If your MAGI is $100,000 or less, you may deduct up to $25,000. If your MAGI is $150,000, your maximum allowance is $0. For taxpayers whose MAGI is between $100,000 and $150,000, their allowance is $25,000 minus $1 for every $2 of MAGI above $100,000. For example, a taxpayer with a MAGI of $122,000 would have a maximum allowance of $14,000 ($25,000 minus one half of $22,000).

Business activities offer a wide array of possible deductions, but also contain myriad rules regarding the proper process for claiming them. To ensure your business activity, whether large or small, is best positioned for the most favorable tax treatment, consult the knowledgeable, creative tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C., who have years of helping taxpayers throughout New York and New Jersey.

To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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