Archive for Passive Income & Losses

Do You Own Multiple Businesses? Consider this Tax Advice for Passive Losses

Any time one of your businesses experiences a loss, you want to be able to claim those losses on your tax return. Unfortunately, the passive loss rules can stand in the way of these deductions, unless you plan ahead. In case you don’t already know the passive loss rules, here’s a breakdown of the requirements for deducting passive losses:

  1. You must participate materially in the business that has losses in order to deduct those losses (or if you group the business with another, you must actually participate in the group); or
  2. If you do not participate materially in the business, you must have other sources of passive income that you can deduct the losses against.

Grouping to Claim Passive Losses

Here’s a likely scenario. A medical doctor owns a medical practice, and she would like to open a physical therapy business, but she does not plan to actually work at the new business. Someone else will handle management of this business, and employees will provide the services. The doctor understands that the business will likely lose money for the first couple of years.

However, the doctor does not have any other source of passive income; her only other business is the medical practice in which she actively participates. Therefore, she has to figure out some other way to avoid passive loss rules and claim her deductions. Aside from deducting the losses from other passive income, she could also wait to deduct the losses in total when she gets rid of her entire interest in this passive business.[1] But, she doesn’t want to do that—she wants the deductions now because she doesn’t plan on selling this business for quite some time.

As you can see from the above points, one option for getting around passive loss rules is to form a group from the multiple businesses you own. So, in order to deduct those losses, she groups her new physical therapy business with her medical practice. “Wait a minute,” you may say. Even if she groups these two businesses together, doesn’t the physical therapy business still have only passive income?

It turns out that in order to meet the material participation requirements, you can group your business together to form suitable economic units.[2] That means the businesses and business activities within the grouping must make sense together based on these factors (quoted from IRS Publication 925):[3]

  1. The similarities and differences in the types of trades or businesses,
  2. The extent of common control,
  3. The extent of common ownership,
  4. The geographical location, and
  5. The interdependencies between or among activities.

Note that each business may conduct multiple sets of activities, and any entity structure may group its businesses or activities into one.[4] Even if you are the sole owner of three business that conduct four separate business activities, you can group all of these into one. Your material participation in the grouping then allows passive loss deductions for any of the business activities.

If you want to take advantage of such a common ownership grouping, you’ll need to make the election on your tax return and attach a disclosure statement.[5] Additionally, you’ll need to attach a statement with your tax return for any year that you add another activity to an existing group or regroup a grouping that was inappropriate. If you group inappropriately and don’t follow the requirements, you could end up losing your deductions because the activities will be treated separately.

Your disclosure statements should include the names, addresses, and employer identification numbers for each of the businesses being grouped together. Once you’ve made the election to group, you’re good to go with claiming deductions on an activity’s passive losses, so long as you meet the material participation requirements for the group. What that typically means is you have to participate in the combined businesses for at least 500 hours per year. Going back to our doctor, if she works at the medical practice for 1,968 hours in the course of a year and never does any work at the physical therapy business, she has met the 500-hour test for the entire group.

Not everyone has two business interests that make sense together as an economic unit. If you, like the doctor, are considering opening a second business, but your second business operates in a completely different way from the first, you may not be able to take advantage of grouping. When that’s the case, you should ask yourself, “Is it even worth it to start a business I cannot deduct losses for?” Remember, your tax deductions can make a big difference in your yearly profit.

Basically, you want to make sure the plans you make for your business ventures are the best choices for your bottom-line. Grouping elections are easy to make for the single-owner business, and the rules apply to real estate rentals, as well. So, if you have taxable income you’d like to offset, grouping may be a solution for your business.

  1. IRC Section 469
  2. Reg. Sections 1.469-4(a); 1.469-5T(a)(1)
  3. Reg. Section 1.469-4(c)(2).
  4. Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), Catalog Number 83479V, p. 4-2.
  5. Rev. Proc. 2010-13

Increase Deductions on Your Vacation Home with a Hidden Tax Technique

Usually, when you want to research which tax deductions are available to you, you go to the IRS’s publications and tax regulations documents. The IRS can even be pretty helpful at times by letting you know exactly what you need to do in order to get your deductions. However, the technique in this article won’t be found in any of the typical tax literature. In fact, you’d only find it if you’ve been reading up on old court cases or tax treatises.

The Precedent

So, how does this tax tactic help you if it’s not approved in IRS documents? Aside from the typical sources for supporting your deduction strategies, you can also use tax court precedents. In 1981, Dorance and Helen Bolton found their money trapped behind vacation home deduction limits, but they decided to get creative and find a way around those limits.

Because they set this precedent, you can legally use the same technique today, even though the IRS doesn’t publicize it for everyone’s use. In fact, the IRS’s calculation methods for vacation homes are much more stringent. Nevertheless, the IRS is required to allow the method used by the Boltons because the tax court has ruled it a legal tax strategy.

How this Money-Saving Strategy Works

Do you have a second home, a ski cabin or beach house for example, that you both rent out and use for your personal use? If so, you’ve probably found that the vacation home rules cap the deductions allowed for rental expenses.[1] Additionally, for properties that qualify as a “residence” those rules are at their most stringent. Your property is considered a residence for tax purposes if you take advantage of its personal use for the greater of the following two time periods:[2]

  • More than 14 days in a year, or
  • More than 10 percent of the days you rent it at fair rental price during the year.

You see, when your home qualifies as a residence, you have to split your deductions between residence and rental property, and that creates two primary disadvantages for you: 1) your rental expenses are limited to your rental income, and 2) part of your mortgage interest and property tax deductions are considered rental expenses, which—because of the limit in #1—reduces the amount of other rental expenses you are able to deduct.

Now, here’s what the Boltons did to mitigate these disadvantages. They were able to come up with a way to decrease the amount of mortgage interest and property taxes that counted as rental expenses. Let’s take a look at how their method differs from that of the IRS:

  • IRS MethodCount the property’s total use. That means of your tenants rent the property for 75 days and you personally use it for 25, you divide the rental use days by the total number of days, 100. The use percentages divide up as 75 percent rental and 25 percent personal. Assuming your mortgage interest and property taxes come to $10,000, you must count $7,500 (i.e. 75 percent of $10,000) towards the rental expense limit.
  • Bolton MethodDetermine percentages for the entire year, not just for days of use. With this calculation, you take that same 75 days of rental use and divide it by 365 days, giving you only 21 percent rental use for the year. Again, given $10,000 in mortgage interest and property taxes, you now take 21 percent of that, getting a rental expense total of only $2,100. The Bolton method leaves you with an additional $5,400 of rental expenses that can be deducted.

To see how the numbers work out after deductions, here’s the Boltons’ case:[3]

  • 91 days of rental use
  • 30 days of personal use
  • 244 unoccupied days
  • $2,700 in gross rental income
  • $3,475 in expenses for mortgage interest and property taxes
  • $2,693 in expenses for rental property maintenance

The Boltons were able to claim an additional $1,738 in deductions. Adjusting for today’s dollars, you can save substantially more than that. This case has been on the books for more than 30 years and remains seldom-used, but the IRS is required by precedent tax law to allow it.[4] Now you know the secret, so start claiming your full rental deductions on your vacation home this year.

  1. IRC Section 280A(e).
  2. IRC Section 280A(c)(5) and (d)(1).
  3. Bolton v Commr., 77 TC 104, aff’d 694 F.2d 556 (9th Cir.).
  4. McKinney v Commr., 732 F.2d 414.

You Can Deduct Rental Losses by Qualifying as a Real Estate Professional

Do you manage rental properties on the side? Even if real estate is not your primary profession, you can benefit from tax advantages by qualifying as a real estate professional. Rest assured, your primary employment does not necessarily inhibit your ability to qualify; however, qualification does depend upon how many hours you put into property management versus other employment. You can even gain the same advantages if your spouse qualifies as a real estate professional (if you file taxes jointly).

What Are the Benefits?

Once you are classified as a real estate professional, you are eligible for passive loss tax deductions. These require the government (as your partner) to pay their portion of the taxes. When you have the proper tax advisor helping you to plan accordingly, you have a good chance of getting your IRS partner to provide their portion earlier. This means you’ll have more money free to invest and build your profits with.

As a qualified real estate professional, you can deduct your rental properties’ passive losses immediately, regardless of each property’s income level. If you do not qualify, you may not be able to deduct rental property losses until after the property is sold (unless your joint income is less than $150,000).

How to Qualify as a Real Estate Professional

Qualification depends on your rental property management spending for the course of the year[1]. You or your spouse will qualify if you:

  • Spend greater than 50 percent of your personal service work time participating in real property businesses that you materially take part in or in real property trades; or,
  • Spend greater than 750 hours of your investment analysis and personal service work time participating in real property businesses that you materially take part in or in real property trades.

Here’s an example. Let’s say you work 926 personal service hours throughout the year managing your properties and 920 hours on your W-2 job running your law firm (not including sick days, holidays, or vacations). In this scenario, you would pass both requirements to qualify as a real estate professional. That means you if you materially take part in your rental properties, you may deduct their losses. Just keep in mind that time spent on investment analysis counts toward the hours requirement but not the greater than 50 percent requirement[2]. Also, one spouse must completely meet the requirements. You and your spouse cannot combine your hours together. However, tax law deems that if one spouse qualifies, then both are considered real estate professionals for tax purposes[3].

What Exactly Is “Real Property Businesses or Trades”?

You may have noticed that the requirements hinge on your time spent in real property businesses or real property trades[4]. The terms apply not only to rental properties. In fact, any of the following count toward your service hours:

  • Rental
  • Leasing
  • Conversion
  • Management
  • Operation
  • Brokerage trade or business (including real estate agents)
  • Construction
  • Development
  • Reconstruction
  • Redevelopment
  • Acquisition

Please note: Any work performed as an employee does not count towards the service hours requirement. The exception to this is if you, as an employee, are a five percent owner in the business[5] (i.e., you own more than five percent of your employer’s capital or profits interest, outstanding stock, or outstanding voting stock.

How Do You Prove It?

Now you know what the requirements are, but the IRS obviously requires proof on your part. They will not simply take your word for it that you spent X number of hours working on your business and trades. Fortunately, the IRS has an audit guide for rental properties that lists two proofs an examiner will check for[6]:

  1. You must log the hours spent and services performed during those hours, and provide this documentation when requested. The requirement to track your service hours is discussed in Reg. Section 1.469-5T(f)(4). Acceptable forms of evidence[7] include identification of provided services and approximate hours spent based on narrative summaries, calendars, or appointment books. Just find a way that works for you to track your time and stick to it.
  2. You must provide documentation detailing the amount of time logged in other activities. This allows the examiner to see whether the claimed hours make sense.

To sum things up, you can increase your legal share of government subsidies pertaining to your rental properties. One way is for your total income to be below the threshold. In that case, you can deduct losses up to $25,000. Otherwise, you must qualify as a real estate professional.

  1. IRC Section 469(c)(7)(B).
  2. Reg. Section 1.469-9(b)(4).
  3. IRC Section 469(c)(7)(B)(ii).
  4. IRC Section 469(c)(7)(C).
  5. IRC Section 469(c)(7)(D)(ii).
  6. IRS Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), pp. 2-5, 2-6.
  7. Ibid., p. 4-7.

Are You a “Dealer” or “Investor” for Tax Purposes?

Tax law is forever classifying people and making structures that either create benefits or disadvantages on your tax return. Part of getting the most from your return is about understanding the definitions of the IRS. Two that seem very similar, but have distinctly different consequences on your taxes, are real estate dealer and real estate investor.

What’s the Downside of Each?

We’ll start by discussing the disadvantages. That’s right—there is no golden choice when trying to figure out if you classify as a dealer or an investor. In either case, there will be some disadvantages.

As a real estate dealer:

  • Your profits are taxed at both the ordinary income rates (up to 35 percent) AND the self-employment rates (up to 14.13 percent).[1]
  • You may not depreciate property that you are holding with the intention of selling.
  • You may not use the tax-favored installment method to report dispositions of your property.
  • And, you may not use the Section 1031 exchange to defer taxes on properties you hold as a dealer.

As a real estate investor:

  • You are subject to the net capital losses limit of $3,000 (applied after gains are offset against losses).
  • You must treat selling expenses as a reduction in sales proceeds, which means those expenses produce benefits at the capital-gains tax rates only.

Admittedly, the dealer gets the lesser deal when it comes to disadvantages. The investor does get to depreciate property, is allowed to sell using the tax-favored installment method, and may choose to use a Section 1031 exchange, thereby deferring taxes on a disposition.

What about the Up Side?

Every coin has a heads and a tails. And, it’s the same with tax designations. Both dealers and investors gain some advantages from their respective positions.

Advantages for real estate dealers include:

  • You are treated as a business and may treat most expenses as ordinary business deductions (advertising, commissions, legal fees, real estate sales, etc.).
  • Your property sale losses are not limited capital loss cap of $3,000 that limits investor properties.
  • Your losses are deducted as ordinary losses.
  • You get to deduct the entire loss (either immediately or using the net operating loss rules to deduct it over time—these rules allow you to carry back your losses up to five years and forward up to twenty years).

Advantages for real estate investors include:

  • Your sales profits are taxed at 15 percent or less, a tax-favored capital gains rate.
  • You are not subject to the self-employment tax.

Practical Application

So, what does all this mean for you and your business? Let’s run through some example numbers. For the example, we’ll say you have a $90,000 profit from a property sale. Based on the tax rates mentioned above, your taxes as a dealer could be as high as $36,370.[2] Your taxes as an investor might be as high as $13, 500.

You can clearly see that having your properties qualify as investment sales generates a considerable tax savings—potentially $22,870!

However, depending upon your business structure and activities, it may not be possible to define all of your property sales as investment sales. No problem. The IRS has no qualms with an individual taxpayer acting as part dealer and part investor. You read that right; you can balance the pros and cons of each situation. It’s simply a matter of taking each property on a case-by-case basis.[3]

Not so fast. You may think the IRS is giving you some kind of free gift by allowing this pick and choose method, but it’s not quite as unstructured as all that. You will be required to make a clear distinction in your record books. You didn’t think the IRS was going to let you off without documentation, did you? And, this means you must decide before-hand which route you’re going with each property sale. You cannot simply go back over your sales at tax time and assign designations. You will have to establish what your intent was with the sale—dealer sale or investment sale.

Tips on Documentation

Good documentation of your purpose and activities helps you to establish your case with the IRS. You should determine, and make note of, your intent for the property throughout the process:

  • When you purchase the property;
  • During your ownership; and
  • At the time you sell it.

If you keep records throughout the process (not just at the time of sale) it gives your case credibility. It’s important to keep in mind, however, that if your return is challenged in court, they will likely examine the sale when they rule on whether you acted as a real estate dealer or real estate investor on a particular property.[4] None of this means that your purpose may not change between the time you buy a property and sell it, but at least you will be prepared to understand and plan for such a scenario.

The All Important Point-of-Sale

Important: The point-of-sale is the most critical part of the process in determining your investor or dealer status. It’s often the deciding factor in IRS decisions. Although a single piece of real estate can have features of both dealer and investor property, it can only be treated as one or the other. Take a look at the characteristics of each from a tax standpoint.

  • Real Estate Dealer—First off, dealer property is held with the intention of being to customers in the ordinary fashion of business or trade.[5] If you buy and sell many properties throughout the year, you are likely a dealer regarding those properties.[6] Unfortunately, the IRS has not established any set number for determining dealer status, so it’s all about making your case. In fact, number is only one factor, and in previous rulings:
  1. A company earned dealer status with only one sale because it had already agreed on sale to a third party prior to purchasing the property itself;[7]
  2. A taxpayer, Mr. Goldberg, did not earn dealer status even with 90 home sales in a year.[8] In his case, the homes were built for rentals and used as such prior to the time of sale.

However, in the majority of cases, more sales equal dealer properties. In addition to the influence of the number of properties sold, real estate that you subdivide also has an increased chance of achieving dealer status,[9] except under Section 1237.[10] Removing a lien can also make a property more salable under the ordinary processes of business[11] (recall that dealer property is sold in the ordinary course of business).

Several other traits indicate a dealer business transaction over investment actions. They include active marketing and sales activities,[12] property held for a short period of time (indicating the intention to turn over the property for profit),[13] generally making your living as a dealer,[14] regularly buying and selling real estate for your own account,[15] and buying property with the proceeds from another property.[16]

  • Real Estate Investor—In contrast to dealer property, investor property is held with the intention of producing rental income[17] or appreciating in value. This means that investor properties are typically held for longer periods of time[18] and are not often sold, unlike the quick turnover of a dealer property.[19] Other situations in which a court may rule your property is an investor property include acquiring the real estate by inheritance,[20] dissolution of a trust,[21] or a mortgage foreclosure.[22] It’s even possible for you to make improvements to such property prior to selling it and still retain investor status.[23] [24] Just don’t put the proceeds into more real estate or subdivide the property[25] if you want to maintain that status.

If you don’t make clear in your documentation which type of property sale you are making, the IRS will make the decision based on their interpretation, and that is not the best situation for you! So, look at those characteristics above again. Since you’re going to know at the outset what your purpose is with each property, you can make sure to include as many of the appropriate features as possible well before the sale.

  1. The usual self-employment tax rate times the Schedule SE adjustment.
  2. Assuming the real estate profits were your only income.
  3. Tollis v Commr., T.C. Memo 1993-63.
  4. Sanders v U.S., 740 F2d 886.
  5. IRC Section 1221(a)(1).
  6. Sanders v U.S., 740 F2d 886; Suburban Realty Co. v U.S., 615 F2d 171.
  7. S & H, Inc., v Commr., 78 T.C. 234.
  8. S & H, Inc., v Commr., 78 T.C. 234.
  9. Revenue Ruling 57-565
  10. IRC Section 1237.
  11. Miller v Commr., T.C. Memo 1962-198.
  12. Hancock v Commr., T.C. Memo 1999-336.
  13. Stanley, Inc. v Schuster, aff’d per curiam 421 F2d 1360, 70-1 USTC paragraph 9276 (6th Cir.), cert den 400 US 822 (1970); 295 F. Supp. 812 (S.D. Ohio 1969).
  14. Suburban Realty Co. v U.S., 615 F2d 171.
  15. Armstrong v Commr., 41 T.C.M. 524, T.C. Memo 1980-548.
  16. Mathews v Commr., 315 F2d 101.
  17. Planned Communities, Inc., v Commr., 41 T.C.M. 552.
  18. Nash v Commr., 60 T.C. 503, acq. 1974-2 CB 3.
  19. Rymer v Commr., T.C. Memo 1986-534.
  20. Estate of Mundy v Commr., 36 T.C. 703.
  21. U.S. v Rosbrook, 318 F2d 316, 63-2 USTC paragraph 9500 (9th Cir. 1963).
  22. Cebrian v U.S., 181 F Supp 412, 420 (Ct Cl 1960).
  23. Yunker v Commr., 256 F2d 130, 1 AFTR2d 1559 (6th Cir. 1958).
  24. Metz v Commr., 14 T.C.M. 1166.
  25. U.S. v Winthrop, 417 F2d 905, 69-2 USTC paragraph 9686 (5th Cir. 1969).

Passive-Loss Rules Got You Trapped? You can Release Rental Property Tax Losses

If you’re feeling the pain from calculating your rental property loss deductions and finding that you can’t get some of that money back, you can thank lawmakers from 1986. That’s when the passive-loss rules came into being. These laws really complicated matters for taxpayers, but this article can help you to understand the ins and outs.

How Passive-Loss Rules Work

Basically, lawmakers have given you three possible tax buckets for any given taxable activity:

  1. Portfolio of stocks and bonds
  2. Active business activities involving material participation
  3. Passive-losses for rentals and other activities you don’t materially participate in

We’ll primarily look at the last one with this article. You’ll be happy to know that you do have some options for getting around the passive-loss problem. With the right knowledge, you can see tax benefits from your rental losses.

Before we delve into the solutions, let’s get an understanding of why you may have issues deducting your rental property losses. In order to get the tax benefit from your rental property loss, you (or you and your spouse) have to meet one of two requirements. To meet the first requirement, you must have passive income, such as from other properties or another source. Otherwise, you have to qualify as a real estate professional and actively participate in your rental property business.

Given those requirements, here’s an example of how your rental property losses can end up trapped and unable to be deducted. For the example, you have only one rental property (i.e. you have no other passive income), and you do not qualify as a real estate professional for tax purposes. If your property has produced a tax loss of $10,000 each year for the past six years, and your taxable income is $180,000, you can’t deduct any of those $60,000 in losses because you don’t meet either of the above requirements, and they can’t be deducted from either of the other income buckets.

Your Options

Let’s take a look at the three options you have for navigating these passive-loss rules. It turns out that even if you don’t meet the above requirements, you may have an opportunity to deduct your losses in certain scenarios.

  • Get Full Loss BenefitsTaxpayers who have a modified adjusted gross income of up to $100,000 can deduct all of their rental losses up to $25,000.[1] As your income rises above $100,000, your deduction is reduced by 50 cents per dollar, and once you reach a modified adjusted gross income level of $150,000, you lose this ability to claim losses easily.[2] For a practical example of how this works, let’s say your modified adjusted gross income from your business was $85,000, and you had rental losses of $21,000. In this case, you would be able to deduct the full $21,000.
  • Waiting for the BenefitRemember the $60,000 that were trapped in the example above? It turns out that you don’t just lose all chance of benefiting from those accumulated losses. They are still tax-deductible, but you have to find a way to release their ability to be deducted. In fact, here are four possible ways to get that money out of waiting:
  1. Change the rental property from passive to non-passive. If you’re the sole owner of your business, and you also own 100 percent of the rental property, you can simply convert half the rental property for business use (such as office space). Now 50 percent of you trapped losses can be released ($30,000) for use against the business income bucket[3]. If you operate as an S corporation, you’ll have to make a self-rental election.
  2. Produce additional passive income. If you produce, for example, $6,000 in passive income, you can release $6,000 of the trapped $60,000. Now, you just have to wait to release the other $54,000.
  3. Qualify as a real estate professional and prove your material participation in your real estate business. This option cannot release funds that have been waiting to be released because your qualification as a real estate professional is evaluated on a yearly basis. However, by qualifying, you are able to release your losses for the current tax year. So, the $10,000 for the year you qualify as a real estate professional will be offset against your business and portfolio income buckets. Other losses will have to be released using one of the other solutions.
  4. Sell your property. This option is further explained below.
  • Releasing the Full AmountIf you don’t meet the modified adjusted gross income threshold to take full advantage of loss deductions, there’s actually a very easy way to release the full $60,000 of our example losses. All you have to do is sell 100 percent of the property. When you sell to a third party, you can deduct the entire $60,000 at once. Here’s how you might handle this on your tax return:[4]
  1. You list your capital gain or loss on IRS Form 4797. It will be listed with your other Section 1231 gains and losses. A net gain will be taxed at the tax-favored rates of up to 15 percent, and a net loss will be limited to $3,000. But, don’t worry—anything over that amount can be carried forward.
  2. You also list any gain that is attributable to real-property depreciation (Form 4797). This will be taxed at the real-property depreciation recapture rate on Schedule D (up to 25 percent).
  3. You put the $10,000 loss for the current tax year on Schedule E.
  4. And, here’s the best part. You put the prior $60,000 of tax loss (in addition to the current year’s $10,000) on Schedule E, which finally ends up on your Form 1040 and the entire $70,000 offsets all your income.

To break it down for you, when you sell your property, you get to snub the passive-loss rules and pretend like they don’t even exist!

Passive-loss rules are frustrating, but know that you can eventually deduct your losses. You can even elect to group together multiple properties and use these exact same solutions. Getting the most benefit from your tax return is all about planning ahead. Now that you know how to get around the passive-loss restrictions, you can start planning for the techniques that work right for you and your properties.

  1. IRC Section 469(i).
  2. IRC Section 469(i)(3)(A).
  3. Reg. Sections 1.469-9(e)(4), Example (ii); 1.469-1(f)(4)(iii), Example 4.
  4. Instructions for Form 8582 (2011), revised Jun. 8, 2012, ps. 7-8.