Albert E. Bergen, CPA

Real Estate Professional Taxes

Who is a Real Estate Professional

One of my most popular blog articles describes how most small landlords are not required to file 1099s for work done on their properties.  That’s true for small landlords, but not for real estate professionals. Some landlords’ real estate activities rise to the level of being a business.  But what constitutes a real estate business?  How else are taxes different for a real estate professional?

Photo of 384 Court Street Auburn, ME 04210

Real estate trades or businesses include all of the following:

  • Development or redevelopment
  • Construction or reconstruction
  • Acquisition and / or conversion
  • Rental
  • Property management
  • Brokerage activity

A taxpayer is considered to be in a real property business under IRC Sec. 469(c)(7) when more than half of the taxpayer’s work during the year is done in real estate trades or businesses where the taxpayer materially participates, and the taxpayer spends more than 750 hours a year working on those real property trades or businesses.

Material participation can be several different things, but for a real estate professional, it typically means spending more than 500 hours per year on the real estate activity, spending over 100 hours per year on the activity when no one else spends more than the taxpayer, or being the only person – owner or not – who spends substantially any time on the activity.

Grouping Activities

Many taxpayers have one or more real estate activities where they meet the relatively low threshold for material participation, but don’t meet the 750 hour or half of their personal service time tests to be considered real estate professionals.  In this situation, the taxpayer may choose to group certain activities and treat them as one activity for both the material participation and real estate professionals tests.  They do this by including a statement with their tax return stating that they intend to elect to treat all rental real estate activities as a single activity pursuant to IRC Section 469(c)(7)(A).

Whether or not it is advisable to group activities needs to be determined on a case-by-case basis.  While in the short-term it may be beneficial if the taxpayer has substantial rental losses and substantial other income, in the longer term it may be harmful.  In particular, suspended losses that have built up can generally all be used at once when the passive activity that created them is completely disposed of.  Without a grouping election, this means that all of the losses from a rental property can be used when the property is sold.  With the group election, any old losses that were built up are trapped until all rental activities are disposed of.

Grouping rental properties to qualify as a real estate professional can provide an advantage when the taxpayer has rental losses they wish to offset against other, active income.  It can also provide a benefit to landlords subject to the Net Investment Income Tax – NIIT – discussed below.

Special Tax Provisions

Rental Losses Allowed

Tax losses from rental properties are normally considered to be passive losses.  This means that they can only be deducted against passive income – for example, income from other rental properties, or income from businesses the taxpayer might own an interest in but not materially participate in.  Most taxpayers are also allowed to deduct up to $25,000 of rental losses under the small landlord exception, but this exception starts to phase out for incomes above $100,000 ($50,000 if married filing separately) and is  not available at all for incomes over $150,000 ($75,000 if married filing separately).

If a taxpayer is considered to be a real estate professional, then the limitation on deducting rental losses does not apply to them, and they can deduct the losses from a rental property without being concerned about the passive lost rules.

1099s Required for Real Estate Professionals

While my other article discussed how small landlords typically don’t need to issue 1099s, the same is not true about real estate professionals.  Because the real estate professional is, by definition, engaged in a trade or business, that professional must file a form 1099-misc for any individual or partnership they pay more than $600  for rent or services in a calendar year.

It is uncommon to qualify as real estate professional on the basis of rental activities alone, and even less common to qualify based on rental activities without deliberately electing to group activities.  This means that most landlords still will not need to file a 1099, and those who do need to file 1099s will typically have either elected to group rental activities for the real estate professional test or materially participate in other real estate activities.  Each rental property is treated as a separate activity unless a grouping election has been made, to a landlord who does not engage in other real estate related trades or businesses will generally not have to file forms 1099 for their rental activities.

Effect on Self Employment Tax

Although a real estate professional with rental properties is considered to be engaged in a trade or business with regard to whether the income and losses are active or  passive, rental income remains free of self-employment tax.  IRC Section 1402(a)(1) defines

Net Investment Income Tax

The net investment income tax (NIIT) was enacted as part of the affordable care act.  It took effect for tax years beginning on or after January 1, 2013, and imposes a 3.8% tax on net investment income for taxpayers whose modified adjusted gross incomes are above certain levels.   Under Section 1.1411, a real estate professional can exclude their net rental income from the NIIT if the rental activity rises to the level of a trade or business.  The code section includes a safe harbor provision, but there it is also possible to qualify based on facts and circumstances.  As a special planning opportunity, Section 1.1411 also allows a taxpayer to re-group previously grouped activities in the first tax year after January 1, 2013 during which the taxpayer would be subject to the NIIT.

A rental loss for a rental real estate professional will also not reduce net investment income.  This can cause investment income to be subject to the NITT for high income real estate professionals, when that tax might be avoided if rental losses were treated as being passive.

Summary

This is only meant to be an overview of tax concepts that affect real estate professionals.  It cannot substitute for specific advice from a qualified tax professional that has been tailored to the facts of a specific situation.  Having said that, the primary benefit of being classified as a real estate professional is the ability to deduct losses that exceed the $25,000 ordinarily available to landlords or when other income is too high to allow the taxpayer to use the $25,000 exception for actively managed rental properties.

2 Comments to “Real Estate Professional Taxes”

  1. […] specific criteria used to determine if a landlord is running a business or merely investing are discussed here, but it is the position of the AICPA and this author that most small landlords remain exempt from […]

  2. Jacob M says:

    Hi Albert, is it your view that the method of holding the rental is relevant for purposes of determining whether it is a business or not? I.e., individually, in an LLC, in a multi-member LLC, etc. If the person is not considered a real estate professional and all real estate income is considered passive (and can’t be used to offset active income), then are 1099s not required regardless of whether an entity is used to hold the real estate?

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