Classify as active or passive for optimal tax benefits?

[Mark Silberman]

My spouse and I own rental properties. Our longstanding property investments had passive loss carryovers from the earlier years that are now going down each year due to passive profits. (The rental market is very strong and rents have gone way up over the years.)

We bought more rental property in more recent years. These more recent purchases are generating profits, but the depreciation write offs translate into a net loss for tax purposes. My spouse works very part time as a teacher, and she spends lots of hours on real estate, researching properties, purchasing, and she is in the process of reactivating her real estate license.

Here is what I am considering. (I haven't yet talked to my accountant about this.) I am looking into classifying our rental property activities in the most tax advantaged fashion possible. If I manage the properties that we have held for a long time that are generating taxable gains, this could allow us to use up the remaining passive losses. If my spouse is active in real estate to the level required by the IRS to make her real estate activities qualify as "active" under the tax code, she could manage our newer properties and allow us to take the tax deductions for active losses after the real estate depreciation deductions.

Does anyone have experience with this type of situation? Any thoughts whether this scenario would be allowed as reasonable and proper from a tax perspective? Any other ideas about structuring this in the best possible fashion from a tax perspective?

[Brandon Hall]

@Mark Silberman frankly I'm a bit surprised you haven't already laid out a plan with your CPA. Maybe you aren't confident in their ability to help you plan?

First things first - if you have a full time job, you cannot qualify as an RE pro. You're wearing a white coat in your profile picture, so I'll assume you are a doctor. This means two things: your income is way above the $150k passive loss limit and your wife will need to be the one to qualify as an RE pro.

It seems you already have a decent grasp on what an RE pro is and how that affects you. To qualify as an RE pro, one needs to demonstrate 750 hours and greater than half of their professional working time being spent in real estate.

However, that's only step one.

Step two is demonstrating material participation.

To materially participate, one generally must demonstrate that they participated in the rental activity for 500 hours.

Here's the problem - each one of your rentals is considered a separate activity for the material participation rules. Thus, your spouse must contribute 500 hours to each property separately in order to materially participate.

Luckily, there is a way around this via a grouping election. We can effectively elect to group all of your rental activities as "one" activity so your spouse must only show she participated in the "one" activity (all of your rentals) for a total of 500 hours.

So your spouse can be a real estate professional, but you will need to group your rentals into one activity to harness any real benefit unless she strategically materially participates in two or three rentals for 500 hours per rental.

The grouping election by the way requires that you group ALL of your rentals. You cannot pick and choose.

Two downsides to the RE Pro and grouping:

1. You cannot activate prior suspended losses. They will remain suspended.

2. If you sell a property that has been grouped, you are deemed to be selling a portion of the entire activity. If you do by sell a material portion of the entire activity, you cannot activiate passive losses to offset your capital gain. Ouch.

Recommendation for you: look to invest in small businesses that currently produce cash flow (not start ups). These are commonly known as PIGs (passive income generators). Maybe you take a small equity stake in a hair salon - the income you earn will be passive and will tap into your suspended passive losses.