Owners of construction companies are often involved in other active areas of real estate such as fix-and-flip projects, property management and development to name a few. When these owners also acquire rental real estate as part of a buy-and-hold strategy, they may wonder if the tax losses typically generated by long-term rental properties (due to mortgage interest and tax depreciation) can be used to offset their other income streams.
Generally, long-term rental properties are considered “passive” by the IRS which typically means losses from these rental properties can only be deducted against income from other “passive” activities. Otherwise, these losses are not deducted and are carried forward to future years. Fortunately for owners of construction companies, they may be able to qualify as a real estate professional and deduct these losses without limitation.
An individual will qualify as a real estate professional if he or she meets both of the following requirements:
- More than 50% of all services you provide (in any industry) must be performed in real property trades or businesses in which you materially participate, AND
- You must provide a minimum of 750 hours to real property trades or businesses in which you materially participate.
What is a “real property trade or business”?
The definition of “real property trades or businesses” is broad and includes: acquisition, conversion, rental, construction, reconstruction, development, redevelopment, property management, operation, brokerage and leasing activities. All of these activities count towards meeting the real estate professional requirements.
What does it mean to “materially participate?”
There are several ways in which you can materially participate in a trade or business but listed below are some of the most common ways:
- You spend more than 500 hours on the activity in the year
- You participate over 100 hours during the year, and no other individual (including non-owners) participates more
- You significantly participate in the activity for more than 100 hours during the year, and your annual participation in all significant participation activities is more than 500 hours.
The IRS generally views each business or rental property as a separate activity which could mean that an individual would need to “materially participate” in each activity. Obviously this becomes challenging when an individual has several businesses and rental properties. The IRS has extended an olive branch to taxpayers by allowing them to make an election to group activities together. This simplifies meeting these “material participation” requirements but requires some analysis and planning as such an election is typically irrevocable and can only be made on an originally filed tax return (not an amended return).
This is a complex area for many in the real estate industry but it also can be an excellent tax planning tool. If you think you may qualify as a real estate professional, please contact us for further assistance.