Chapter 10 Commingling rental losses with other income This chapter reviews the use of rental operating losses to offset business income, investment income and profits. Chapter 10 Outline The part-time landld Repting rental operating loss Real estate related business Time spent serving others The landld s material participation Material participation must be active The 500-hour landld The over-100-hour landld Five out of ten The mutually exclusive $25,000 deduction active participation occupancy rule owner-operat Chapter 10 Terms reptable operating loss services rendered The part-time landld A real estate broker owns rental properties and a brokerage business. The broker wks 30 hours a week in his brokerage business, acting on behalf of clients. He spends an average of ten hours a week on management, care and maintenance of his own rentals. In managing his rentals, the broker interviews prospective tenants, checks their credit and pri rental histy and prepares and signs all leases. He also collects rents and arranges f all repairs and maintenance. At the end of the year, the broker has a reptable net operating loss from his rental activities. Can the broker use the loss from his rentals to offset any income from his brokerage business? Yes! An owner who renders services acting f his own account as a landld, invest, developer builder, acting on behalf of others as a real estate licensee, qualifies to offset his business income and investment profits with rental operating losses. This offsetting of income is called an adjustment, to reduce the owner s adjusted gross income (AGI). [Internal Revenue Code 469] Repting rental operating loss All income, profit loss from residential and nonresidential rental properties with an average occupancy of me than 30 days is repted by the owner in the passive income categy, separate from income in the trade/ business income categy, such as brokerage 81
Tax Benefits of Ownership, Third Edition income, the investment/ptfolio income categy, such as carryback notes land held f profit on a resale. Reptable operating losses from a single rental property first offset operating income and sales profits from other rentals properties of the owner repted in the passive income categy. Any losses remaining after offsetting income and losses between all the rental properties held by the owner then spill over to offset passive categy income from other sources, such as income received as a member in a partnership, limited liability company (LLC) S cpation which owns a business operated by someone other than the owner of the rentals. Unless allowed to use the rental losses to offset income generated by the owner under business ptfolio income categies, rental operating losses remaining after offsetting income and profits within the passive categy are reallocated back to the rental properties that generated the operating losses, not back to those with an operating net income. The reallocated losses are accounted f as suspended losses. However, the rental owner may annually qualify to use the rental losses as either: an adjustment to reduce the AGI; a deduction from the AGI of up to $25,000 annually. Consider a married couple who incurs a reptable operating loss on their rental property, comprised of both residential and nonresidential property. Neither spouse is in a business related to real estate. One spouse is a doct and manages the couple s rentals. The other spouse is not involved in any aspect of the rentals. Because the couple s AGI exceeds $150,000, the couple does not qualify to deduct any part of their loss from their AGI under the limited $25,000 annual operating loss deduction rules. If they qualified, the loss would reduce the taxable income on their joint return. [IRC 469(i)(3)(A)] However, either spouse, independent of the other, can qualify the rental operating loss as an adjustment in der to reduce their AGI. [IRC 469(c)(7)(B)] To qualify rental operating losses as an AGI adjustment (not a deduction), the unemployed spouse must assume all duties as the manager of the couple s rentals. As manager, the spouse must spend sufficient time to qualify as both: an owner-operat of a real estate related trade business; and a material participant in the ownership of the rentals. [IRC 469(c)(7)(B)] Real estate related business The real estate related trade business of a landld, acting on his own behalf representing others as a broker builder, includes real estate activities such as: development redevelopment; construction reconstruction; acquisition; conversion; renting; operation; management; 82
Chapter 10: Commingling rental losses with other income Fig ure 1 Landld with rental operating losses Ma te rial par tic ipant as owner of real es tate. Owner/operat of real-estaterelated trade business. 500 hours an nu ally in man age ment de ci sions. 100 hours an nu ally, but not less than other co-owner man ager. Categies include real estate services in: de vel op ment con struc tion ac qui si tion con ver sion rent als op er a tion man age ment leas ing bro ker age Sub stan tially all man age ment de ci sions. 750 hours spent annually in all real-estate-related business (including landlding). Qualify during any 5 of the preceeding 10 years. Me than one half of time spent in all trade businesses is spent in real-estate-related businesses (including landlding). Rental op er at ing loss is in cluded in Ad justed Gross In come (AGI) if an in di vid ual qual i fies as both a ma te rial par tic ipant in rent als and an owner/op er a t real- es tate-re lated trade business. 83
Tax Benefits of Ownership, Third Edition leasing; brokerage. [IRC 469(c)(7)(C)] F a landld to qualify as an owner-operat of a real estate related trade business, two criteria must be met: the business must render professional real estate services, manage, invest in develop real estate f their own accounts; and the landld must spend a minimum amount of time in the real estate related businesses. [See Figure 1] Consider a landld who spends sufficient time acquiring, managing leasing his own rentals. He qualifies as wking in a real estate related business, even though his income losses from rental operations is always repted as passive categy rental income and cannot be classified as trade business categy income. When the landld s business and rental activities qualify as real estate related business activity, adjustments to the AGI may then include his rental operating losses, which are otherwise excluded. However, rental operations alone qualify as a real estate related trade business if the landld spends sufficient time on his duties as a landld. [See first tuesday Fm 351] Thus, f the landld to offset business investment income with his rental operating losses, he must annually spend a minimum amount of time rendering real estate services f others and f himself, as follows: me than half of his time spent rendering services must be in real estate related trades businesses (landlding/developing, brokerage); and me than 750 hours of the entire year must be spent in real estate related trades businesses (a 15-hour weekly average). [IRC 469(c)(7)(B)] To determine whether the individual spends sufficient time in real estate related trades businesses, time spent in all his real estate related trades businesses and landlding is combined. Time spent serving others Consider a practicing doct who is married and owns several rentals. The doct averages 30 hours weekly as a physician and 15 hours weekly tending to the rental properties. The doct s spouse is uninvolved in the acquisition and management of the rentals. While the doct has an annual reptable income from his practice, the rentals are highly leveraged and produce an overall reptable operating loss. Does the doct qualify as an owner-operat of a real estate related trade business to offset other income with the rental operating loss? No! While the doct spent 750 hours during the year (15 hours weekly) actively participating in a real estate related trade business (the ownership of rentals), the amount of time spent as a landld was not me than half of the total time spent tending to both his rentals and his patients, called rendering services. [IRC 469(c)(7)(B)] Also, time spent by the doct managing his ptfolio categy investment (trust deed 84
Chapter 10: Commingling rental losses with other income notes and land held f profit) does not qualify as professional services rendered in a real estate related trade business. The landld s material participation Now consider a practicing doct who is married and owns several rentals that are community property. The doct s spouse wks me than 15 hours weekly acquiring and managing the rentals. The spouse has no other job and the couple files a joint return. Does the couple qualify as owner-operats in a real estate related trade business because of the spouse s involvement in the rental activity? Yes! F married couples filing jointly, one spouse can separately satisfy the requirements to qualify the couple as owner-operats of a real estate related trade business. [IRC 469(c)(7)(B)] Here, the amount of time the spouse spent operating the couple s rentals was sufficient to qualify the rentals as a real estate related trade business. The spouse qualified because: me than half of the total time providing services of all types was spent in a real estate related trade business (the rentals); and me than 750 hours of the year were spent in a real estate related trade business (the ownership of rentals). [IRC 469(c)(7)(B)] Thus, the combination of the couple s joint ownership and rental activity qualifies them as rendering services in a real estate related trade business. In der to use the couple s rental operating losses to offset other income, the managing spouse must demonstrate a material participation as a landld in the rental operations, in addition to ownership and services rendered. To qualify as a material participant, the managing spouse must meet one of the following criteria: time spent handling the rentals exceeds 500 hours annually (about ten hours weekly); time spent handling the rentals exceeds 100 hours annually (about 2 hours weekly), but is not less than the amount of time spent by any other coowner manager; the managing spouse s wk includes substantially all management of the rentals; either spouse individually qualified during any five of the preceding ten years. [26 Code of Federal Regulations 1.469-5T(a)] In this case, since the managing spouse makes all decisions in connection with the management of the rentals, thus satisfying one of the criteria, any rental operating losses can be used to adjust the couple s AGI. Material participation must be active Consider an income property owner, whose primary occupation is not a real estate related business. The property owner participates in the operation of his rental property, and also spends time on call during the hours when he is not specifically operating his rental property. The property owner keeps a log of his time spent operating his rentals, totaling over 750 hours f the year, including on call time. 85
Tax Benefits of Ownership, Third Edition Is the property owner entitled to rept his rental income losses under the passive income categy to offset other income as an adjustment to his AGI? No! On call activity does not qualify as material participation in the operation of rental property, and the property owner therefe does not have the 750 required hours to be qualified as a material participant and write off rental losses as a reduction in AGI. [Moss v. Commissioner (2010) 135 TC 18] The 500-hour landld Consider a real estate broker who wks full time at his brokerage business and owns rental properties as a co-owner with other invests. The broker reviews and approves tenants and leases, and collects and deposits rents. He spends an average of at least ten hours weekly managing the rentals. One of the invests spends me time than the broker does in the management of the rentals. The rentals generate a reptable operating loss f the year, due to interest deductions, depreciation schedules and vacant units. Can the broker write off his share of the rental operating loss to offset his brokerage income even though his co-owner is me involved in management than he is? Yes! First, as a broker operating a real estate brokerage service, he qualifies as rendering services in a real estate related business. Secondly, the broker qualifies as a material participant in his rentals since he spends me than 500 hours of the year on the management of the units. [26 CFR 1.469-5T(a)(1)] Thus, he is allowed to use the rental losses to offset his brokerage income and lower his AGI, called an adjustment, not a deduction. The co-owner, f the same reason, also qualifies to write off the rental loss against other income. The over-100-hour landld Now consider a licensed sales agent who owns rentals and wks 40 hours weekly as an agent f a real estate broker. The agent s income is repted under his independent contract tax status. The agent handles all aspects of management and operation of his rentals and arranges f their maintenance and repair. He spends an average of six hours weekly on his rentals. The agent also employs an on-site resident manager who averages less than six hours a week deciding what repairs to make and which potential tenants qualify to lease. Can the agent write off his rental operating losses against his real estate sales income? Yes! The agent s real estate employment as an independent contract to a broker qualifies as rendering services in a real estate related business. Also, the agent s landlding activities meet the standard f material participation since he wks me than 100 hours annually on his rentals and his resident manager does not spend me hours managing the rentals than he does. [26 CFR 1.469-5T(a)(3); IRC 469(c)(7)(C)] Now consider a broker who owns a brokerage business and income-producing real estate. The broker wks approximately 40 hours weekly on his brokerage business. The broker s time spent on the management and maintenance of the duplex is relatively minimal, averaging approximately six hours monthly. The broker handles all aspects of the management and operation of the rental, except f the maintenance and repair of 86
Chapter 10: Commingling rental losses with other income the units, which he arranges to be done by a handyman. The handyman wks me hours monthly in repairing and maintaining the rental than the broker does in managing the rental. Can the broker use any rental operating loss to offset other income from his brokerage business? Yes! The broker can use any rental operating loss to offset other income as an adjustment to his AGI since the broker perfms substantially all of the management of the units. Maintenance and repairs, which the handyman perfms, are not management activities. [26 CFR 1.469-5T(a)(2)] Five out of ten Consider a developer who owns several rentals. In most years, the developer wks an average of 25 hours weekly on his development projects and 15 hours weekly managing his rentals. The developer was qualified as a material participant in his rentals f the last four years, was not qualified f one year befe that, and was qualified f the two years pri to that a total of six out of the last ten years. In the current year, sales of new houses were up. Consequently, the developer wked 40 hours ( me) weekly on his development business and hired a property manager to operate the rentals, leaving the developer only marginally involved in the rentals. His development business showed a reptable income this year, but his rentals had a reptable operating loss. Can the developer use his rental operating loss as an offset against his business income? Yes! Although the developer is not a material participant in the day-to-day decisionmaking process of managing his rentals this year, he qualified as a material participant in at least five of the last ten years. [26 CFR 1.469-5T(a)(5)] The mutually exclusive $25,000 deduction To be classified as passive income categy property, rentals only need to be occupied by tenants f an average of me than 30 days. The over 30 days occupancy rule, together with the owner s active participation in its operations, locks repting of a property s income, expenses, interest and depreciation in the passive income categy as rental income. [See IRS Fm 1040, Schedule E] Rental operating losses remaining after the offset of other rental and passive business income profits can be deducted from the landld s AGI in amounts of up to $25,000 a year to establish the landld s taxable income if, among other tests, the landld qualifies as an active participant in his rental operations. To be active means a landld holds primary responsibility f the maintenance and management of the real estate under leases entered into with tenants, even though a broker may exclusively handle all the rental activities as the agent of the landld under a property management agreement. The $25,000 rental operating loss deduction is available f those landlds who do not qualify as material participants f the rental operating loss adjustment to the AGI. Obviously, the $25,000 loss deduction from the AGI will not be needed if a landld s time and efft operating his rentals qualifies any rental operating losses as an adjustment to establish his AGI rather than a deduction. 87