Tax Savings for Real Estate Professionals

The last two years have been marked by a major slowdown in the real estate and construction arena leading to large losses for many businesses, especially in the real estate and construction markets.

Generally, rental real estate properties are treated as separate activities and considered passive investments, which means their losses are not currently deductible. The result is a financial predicament in which taxpayers are seeing declining cash reserves while saddled with suspended passive losses.

But by taking advantage of an opportunity to combine separate real estate interests as a single real estate activity, real estate professionals can offset taxable income with rental real estate losses. This election is available only for qualifying real estate professionals who materially participate in real estate activities.

An individual qualifies as an eligible real estate professional if both of the following criteria are met:

• More than 50 percent of the personal services performed by the taxpayer in all trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates. A real property trade or business is broadly defined and includes real property development, construction, acquisition or conversion, rental, management or operation, leasing, and brokerage activities.
• The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.

General Rules: Suspension of Passive Activity Losses

Rental real estate activities are considered passive investments by the IRS and analyzed on an activity-by-activity basis. To avoid tax shelter schemes, Congress forces taxpayers to “materially participate” in an activity in order to deduct losses generated from that activity.

It is often difficult for taxpayers to satisfy the IRS’s general material participation thresholds on an activity-by-activity basis. The most common material participation tests include:

• Taxpayer participates in the activity for greater than 500 hours in the taxable year.
• Taxpayer’s participation constitutes substantially all participation from all individuals in the activity.
• Taxpayer’s participation is greater than 100 hours and no other individual participates greater than 100 hours.

Typically, taxpayers who cannot meet these tests are unable to deduct passive losses, which means those losses are only useful in offsetting income generated from other passive activities. If there is no passive activity income, as is the case for many real estate professionals in today’s market, any passive activity losses are suspended and carried forward to subsequent tax years.

Elect to Aggregate Real Estate Interest as a Single Activity

It is much easier for a taxpayer to meet the material participation standards for real estate professionals if they aggregate their various rental real estate interests as a single activity for tax purposes. The taxpayer makes this election by attaching a statement to his timely filed tax return indicating that he is a qualified real estate professional. This election is binding for the taxable year it is made and for all future tax years, unless there is a material change in the taxpayer’s qualifying status.

The immediate impact of satisfying the material participation qualifications is a transformation of current year passive losses to non-passive. All current non-passive losses are deductible on a taxpayer’s tax return as an ordinary deduction. However, passive losses suspended in prior years do not become ordinary losses.

Bolster Cash Flow Through Federal/State Carryback Claims

By electing real estate professional status, a taxpayer’s current ordinary losses will likely increase significantly. The IRS also allows individuals to file claims to “carryback” current year losses — that is, to apply current year losses against income in prior years — and receive a refund of federal taxes previously paid. There is a two-year period for which federal losses can be carried back, so real estate professionals should evaluate the benefits of a carryback loss as soon as possible. Most states also have a two-year carryback period to recover taxes; however, this should be analyzed on a state-by-state basis.

Losses generated in 2008 can be carried back two years to the 2007 and 2006 tax years. To take advantage of these carryback losses, taxpayers should file their 2008 individual tax returns as soon as possible and then immediately file carryback claims to 2006 and 2007 for federal and state purposes.

Porter Keadle Moore, LLP is a founding member of ProfitCrew, an association of accountants and business advisors dedicated to helping construction companies build profitable businesses. For information, contact Adam Polakov at apolakov@pkm.com or Arvil Stanford at astanford@pkm.com or visit www.pkm.com.