Real Estate Professional Passive Activity Loss

The real estate professional passive activity loss (PAL) income limitation refers to the ability of individuals who qualify as real estate professionals to avoid the typical passive activity loss rules, which generally restrict the ability to deduct losses from passive activities against ordinary income. In normal circumstances, losses from passive activities (like rental property) can only offset other passive income. However, real estate professionals may have more favorable treatment, allowing them to deduct losses against ordinary income, such as wages or business income.

Here are the main points:

1. Definition of a Real Estate Professional:

To qualify as a real estate professional for tax purposes under Section 469(c)(7), a taxpayer must meet two criteria:

• More than 50% of your personal services in trades or businesses during the year must be spent on real property trades or businesses (i.e., activities like managing, renting, or developing real estate).

• You must spend at least 750 hours during the year in real estate activities.

2. Impact on Passive Activity Losses:

Normally, rental activities are considered passive activities by default. Under the passive activity loss rules, you can only offset passive losses against passive income (i.e., rental losses can offset rental income but not wages or business income).

However, if you qualify as a real estate professional, rental real estate losses are not automatically considered passive and can offset non-passive income (like wages or other active business income). This allows you to use rental property losses to reduce your overall taxable income.

3. Material Participation:

Even if you're a real estate professional, you must materially participate in the rental activity to deduct the losses. Material participation means being involved in the property management on a regular, continuous, and substantial basis. If you don’t meet this requirement, the losses may still be considered passive.

4. Special $25,000 Deduction for Non-Real Estate Professionals:

There is also a special rule for individuals who do not qualify as real estate professionals but actively participate in rental real estate. In this case, you may be eligible to deduct up to $25,000 of rental real estate losses against other income, subject to a phase-out once your adjusted gross income (AGI) exceeds $100,000 (phase-out completely at $150,000 AGI).

5. Limitations:

• If you don’t qualify as a real estate professional, or if you don't materially participate in the rental activities, the losses are considered passive.

• For those who qualify, it’s important to keep records proving you meet the 750-hour and 50% criteria to defend your position in case of an IRS audit.

Summary:

For real estate professionals, passive activity loss income limitations can be avoided, and rental property losses can offset other income (like wages) if you meet the necessary criteria for the real estate professional status. This can be highly beneficial for tax planning, but it requires careful record-keeping and a clear demonstration of your involvement in the real estate activities.