Passive Losses and Their Role in Your Tax Planning

Navigating the complex terrain of tax laws is an essential skill for business owners, particularly when it comes to Passive Activity Losses (PALs). Our previous articles, Passive Activity Losses: A Simplified Overview, and Passive Activity Losses: Active Participant vs Activity provided important foundations for understanding these rules. If you haven’t yet read them, we recommend doing so to gain a baseline understanding before delving into the more complex rules and choices addressed here.

Why Would You Want to Materially Participate in an Activity?

Prior to the Tax Reform Act of 1986, the Passive Activity Loss rules did not exist, and taxpayers could often harvest their tax losses immediately. Wouldn’t it be nice to be able to do that now? You may be able to accomplish this by using the Material Participation Test to bypass the passive activity rules.

What is Participation?

In general, participation is any work you and/or your spouse does in connection with an activity in which you own an interest. There is an exception: you do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity.

Material Participation & the Tests

A trade or business activity isn’t a passive activity if you materially participated in the activity. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:

  • You participated in the activity for more than 500 hours.
  • Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
  • You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including those who didn’t own any interest in the activity) for the year.
  • The activity is a significant participation activity (SPA), and you participated in all SPA’s for more than 500 hours. An SPA is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
  • You materially participated in the activity (other than by meeting this test) for any five of the 10 immediately preceding tax years.
  • The activity is a personal service activity in which you materially participated for any three preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting or any other trade or business in which capital isn’t a material income-producing factor.
  • Based on all the facts and circumstances, you participated in the activity on a regular, continuous and substantial basis during the year.

The Real Estate Activity Exception

In general, a taxpayer’s trade or business activity is passive and their losses in that trade or business are limited by the passive activity rules, unless the taxpayer materially participates in that activity by satisfying any one of the previously mentioned material participation tests. With that said, in order to bypass the passive activity rules for rental activities, you must also qualify as a real estate professional for the year.

How to Qualify as a Real Estate Professional

As previously noted, you must be able to pass the previously described material participation Test. In addition, a real estate professional must also meet both of the following additional requirements:

  • You must spend over 50% of the time you devote to performing personal services (in other words, working) during the year in real property businesses in which you materially participate.
  • You must spend over 750 hours performing personal services in real property businesses in which you materially participate.

It is critical to note that spouses cannot combine their efforts to comply with these rules. At least one of them must qualify as a real estate professional on their own. With that said, if they are filing a joint return, only one of them needs to qualify for the real estate professional status to be applicable.

IRS guidance indicates that you can qualify as a real estate professional if you work full-time in a business directly involved in real property transactions. Following is a list of real estate transactions found to involve real property transactions:

  • Development
  • Redevelopment
  • Construction or reconstruction
  • Acquisition
  • Conversion
  • Rental
  • Operation
  • Management
  • Leasing
  • Brokerage

Example: If you own 5% or more of a construction company, your full-time job may be a real property trade or business, which means you may already qualify as a real estate professional. The reason for this is the IRS has taken the position that certain types of construction are not real property trades or businesses. For example, they take the position that an HVAC contractor is not a real property trade or business.

Use of Aggregation to Qualify as a Real Estate Professional

In our article Passive Activity Losses: Active Participant vs Activity, we briefly compared the advantages and disadvantages of combining several passive activities into a single group. Similarly, aggregation can be used to pass the tests to be qualified as a real estate professional to bypass the passive activity rules. The two concepts are very similar and carry similar advantages and disadvantages.  In both cases, this is a choice best discussed directly with a tax professional.

Questions?

Navigating the intricacies of passive activities and their tax implications can be challenging, but with the right guidance and understanding, you can make informed decisions to optimize your tax position. Tax services are not just about keeping in compliance with filing requirements; they are also about leveraging opportunities. An experienced tax advisor can help you not only understand the rules but also how to capitalize on them to your advantage. Whether it’s finding ways to utilize suspended losses or determining how best to categorize your investments, a proactive approach can yield significant benefits. Contact an Adams Brown advisor today to request a tax planning meeting.