tax deductions on rental property

[Edward Barnes]

My wife owns a condo about in 2008. I married into this pig (the condo, not my wife) as we filed jointly last year. It loses about $500/mo after everything's said and done. Doing the taxes last year it wouldn't let me declare a loss on the property as it was considered "passive income" because I have a property manager and don't actively manage the property myself. Is this correct? If so, my property manager's costing me more than 10% of rent.

[Brandon Hall]

@Edward Barnes

There is a lot more to it than that. My advice is to seek a professional. I'll try to explain the various levels of participation and how you can take passive losses against ordinary income.

Under Section 469, an activity is classified as passive if the activity is a trade or business activity in which the taxpayer does not materially participate during the year or a rental activity.

Section 469(i)(1) permits certain taxpayers who actively participate in rental real estate activity to deduct up to $25,000 of losses arising from the rental real estate activity, if the taxpayer cannot meet the material participation test required to be categorized as a real estate professional.

The $25,000 permitted loss is reduced by 50% of the taxpayer's adjusted gross income (AGI) in excess of $100,000. So married filing jointly couples that have an AGI exceeding $150,000 will not be allowed to claim a passive loss. 

The exception is if you can qualify for the real estate professional status. A taxpayer will be considered a real estate professional if more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates AND the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

If you believe you have qualified as a real estate professional, you must then establish material participation in the rental activity. Material participation can be established by satisfying one of the following tests:

1. The individual participates in the activity for more than 500 hours during such year.

2. The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.

3. The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.

4. The activity is a significant participation activity for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours.

5. The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year.

6. The activity is a personal service activity and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.

7. Based on all of the facts and circumstances the individual participates in the activity on a regular, continuous, and substantial basis during such year.

If you participate in multiple rental activities, you will more than likely need to make the election to group all rental activities as one, otherwise you stand little chance at meeting the material participation requirements. 

In summation - if you are trying to take advantage of real estate tax loopholes, it's best to see a professional. Applying passive losses to ordinary income can be quite a difficult task, and you may end up hurting yourself in the process, so you need to make sure you are receiving holistic and competent advice.