All Forum Posts by: Tom Wheelwright

Even if you have strong positive cash flow from your rental real estate, chances are you still have a loss for tax purposes due to the depreciation deduction.

This is a great tax strategy because your positive cash flow is sheltered from tax. But, it can be even better if you are able to take your losses against your other income (like your income from your job or the business that you run).

The general rule for rental real estate losses is that they are passive. This means they can only be taken against passive income. The income from your job and the business you run is active income so your rental losses cannot shelter this income. However, there are two exceptions to this rule.

Exception #1: "Active Real Estate" exception.

Exception #2: "Real Estate Professional" exception. (See my recent post about this).

The Background on the Active Real Estate Exception:

Rental real estate, in many cases, is held to provide financial security to individuals with moderate incomes. Because of this Congress believed that a rental real estate investment in which a taxpayer has significant responsibilities and which served a significant non-tax purpose should be treated differently than the activities meant to be limited under the passive loss provisions. So Congress created the active rental real estate exception.

- How It Works -

If you are active in your rental real estate activities you may be able to deduct up to $25,000 of your rental losses against other ordinary income. We say may be because there are income limitations which phase out the $25,000 deduction. The phase out will start when your adjusted gross income exceeds $100,000 and end when your adjusted gross income is at $150,000. This means that for every $2 over $100,000 of adjusted gross income you will lose $1 off the $25,000 deductible amount. For example if your adjusted gross income is $120,000 you will have to reduce the $25,000 exception by $10,000 and the most rental real estate losses you can deduct will be $15,000 for that tax year.

Don't let your high income penalize you! Learn my tax secrets to increase your cash flow by uncovering the hidden cash flow in your real estate. Several of my secrets reveal how to legally get around these income limitations!

What constitutes active participation?

Active participation exists so long as you participate, in the making of management decisions or arranging for others to provide services (such as repairs), in a significant and bona fide sense. Also, you must have at least a 10% interest in the activity at any time during the year. For more information about how to make the most out of your rental real estate, contact your Tax Coach.

[EDITED BY MODERATOR. No solicitations in the forum please.]

The IRS has really been attacking this lately - and it would be in your best interest to have very good / thorough documentation.

To answer your other questions - again it's my most common answer - "It all really depends".

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Even if you have strong positive cash flow from your rental real estate, chances are you still have a loss for tax purposes due to the depreciation deduction.

This is a great tax strategy because your positive cash flow is sheltered from tax. But, it can be even better if you are able to take your losses against your other income (like your income from your job or the business that you run).

The general rule for rental real estate losses is that they are passive. This means they can only be taken against passive income. The income from your job and the business you run is active income so your rental losses cannot shelter this income. However, there are two exceptions to this rule.

** Exception #1: "Active Real Estate" exception. **

The Background on the Active Real Estate Exception

Rental real estate, in many cases, is held to provide financial security to individuals with moderate incomes. Because of this Congress believed that a rental real estate investment in which a taxpayer has significant responsibilities and which served a significant non-tax purpose should be treated differently than the activities meant to be limited under the passive loss provisions. So Congress created the active rental real estate exception.

- How It Works -

If you are active in your rental real estate activities you may be able to deduct up to $25,000 of your rental losses against other ordinary income. We say may be because there are income limitations which phase out the $25,000 deduction. The phase out will start when your adjusted gross income exceeds $100,000 and end when your adjusted gross income is at $150,000. This means that for every $2 over $100,000 of adjusted gross income you will lose $1 off the $25,000 deductible amount. For example if your adjusted gross income is $120,000 you will have to reduce the $25,000 exception by $10,000 and the most rental real estate losses you can deduct will be $15,000 for that tax year.

Don't let your high income penalize you! Learn my tax secrets to increase your cash flow by uncovering the hidden cash flow in your real estate. Several of my secrets reveal how to legally get around these income limitations!

What constitutes active participation?

Active participation exists so long as you participate, in the making of management decisions or arranging for others to provide services (such as repairs), in a significant and bona fide sense. Also, you must have at least a 10% interest in the activity at any time during the year.

** Exception #2: "Real Estate Professional" exception. **

What is a Real Estate Professional?

First, let's dispense with one myth: Real Estate Professional status does not mean you have to hold a real estate license. Rather, it is a designation you obtain by meeting certain specific requirements. If you qualify as a real estate professional you can deduct all your current year rental real estate losses against other income without limitations.

Requirement #1

The first requirement is that you spend more than 750 hours in real estate trades or businesses in which you materially participate.

What is a real estate trade or business? A real estate trade or business is defined as ANY real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

The 750 hours test must be met for each activity. So for example, say you have three rental properties. The general rule is that you have to perform at least 750 hours on activities related to EACH of those three properties. Fortunately, there is an exception to this rule. If you make the election to aggregate all of your rental real estate activities into one activity, you only have to meet the 750 hours requirement once for the tax year.

What types of activities qualify as real estate professional activities? Activities such as:

- Searching for possible rental properties
- Attending real estate seminars or reading real estate books
- Meeting with real estate agents and viewing properties
- Meeting with mortgage brokers with regards to getting loans on properties
- Travel time to and from the seminars and your property searches
- Preparing your bookkeeping and tax information for your rental properties
- Time spend buying or selling properties (i.e. signing the closing documents)
- Studying and reviewing financial reports (Investor-type)
- Preparing summaries or analyses for personal use (Investor-type)
- Monitoring finances or operation in a non-managerial capacity (Investor-type)

An important note to the investor-type activities mentioned above is that these activities can only be counted towards real estate professional time if you are involved in the day-to-day operations or management of the activity for which you perform those tasks. Essentially, this means that if you have an independent property manager and your only real estate business is your rental properties, you probably will not qualify as a real estate professional.

Requirement #2

The second requirement is that you spend more time in your real estate trades or businesses than in ALL OTHER trades or businesses combined. Time spent as an employee in real estate activities is counted only if you are a more than a 5% owner in that business.

- What You Need to Do -

You have to meet the above requirements each year. So, you could be a real estate professional one year but not the next. Only one spouse needs to meet the requirements in order for a married couple to take advantage of the benefits provided by the real estate professional status.

The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Documentation required includes the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative statements.

To be honest with you (and I know it's not the instant answer that you would hope for), this is my most common answer for most questions I am asked. "It depends."

There are so many variables as every person's situation is different. My best advice for you would be to ask your tax coach. They would have a much better grasp of your situation, and would be able to advise if it would be most beneficial to you.

If you own rental real estate, there are three different ways to treat your rental losses depending on your status. One of these is "Real Estate Professional."

First, let's dispense with one myth: Real Estate Professional status does not mean you have to hold a real estate license. Rather, it is a designation you obtain by meeting certain specific requirements. The first requirement is that you spend more than 750 hours in real property trades or businesses in which you materially participate. The second requirement is that you spend more time in your real property trades or businesses than in ALL OTHER trades or businesses combined. Time spent as an employee in real property activities is counted only if you are a more than a 5% owner in that business. If you qualify as a real estate professional you can deduct all your current year rental real estate losses against other income without limitations.

What is a real property trade or business? A real property trade or business is defined as ANY real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

You have to meet the above requirements each year. So, you could be a real estate professional one year but not the next. Only one spouse needs to meet the requirements in order for a married couple to take advantage of the benefits provided by the real estate professional status.

The 750 hours test must be met for each activity. So for example, say you have three rental properties. The general rule is that you have to perform at least 750 hours on activities related to EACH of those three properties. Fortunately, there is an exception to this rule. If you make the election to aggregate all of your rental real estate activities into one activity, you only have to meet the 750 hours requirement once for the tax year.

What types of activities qualify as real estate professional activities? Activities such as:

- Searching for possible rental properties
- Attending real estate seminars or reading real estate books
- Meeting with real estate agents and viewing properties
- Meeting with mortgage brokers with regards to getting loans on properties
- Travel time to and from the seminars and your property searches
- Preparing your bookkeeping and tax information for your rental properties
- Time spend buying or selling properties (i.e. signing the closing documents)
- Studying and reviewing financial reports (Investor-type)
- Preparing summaries or analyses for personal use (Investor-type)
- Monitoring finances or operation in a non-managerial capacity (Investor-type)

An important note to the investor-type activities mentioned above is that these activities can only be counted towards real estate professional time if you are involved in the day-to-day operations or management of the activity for which you perform those tasks. Essentially, this means that if you have an independent property manager and your only real estate business is your rental properties, you probably will not qualify as a real estate professional.

The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Documentation required includes the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative statements. Documentation is the key when claiming real estate professional status. Most taxpayers who lose in the tax courts lose because of poor documentation. Although documentation through a reasonable means is pretty vague, the tax regulations are clear that post-event "ballpark guesstimates" are not permitted and will not hold up in the tax courts.

Real Estate Professional status is such an important designation for a high-income real estate investor that we strongly recommend you spend time with your Tax Coach to determine if and how you can become a Real Estate Professional and deduct all of your rental losses.

Are you ready to permanently reduce your taxes?

The Limited Liability Company (LLC) is a terrific tax entity. The number one reason is its flexibility. Specifically, an LLC can be taxed as:

- a sole proprietorship
- a partnership
- a C corporation
- an S corporation

Do you know how your LLC is taxed?

If your LLC did not make an election, then it is taxed as the default classification. The default classifications are:

If your LLC has one member (owner), then it is disregarded for tax purposes. This means that all the LLC activity is reported by the owner and the LLC files no separate federal tax return.

*Important note: Some sates require disregarded LLCs to file a state tax return.

If your LLC has more than one member, then it is taxed as a partnership and files a partnership tax return.

*Special rule: If you and your spouse are the only owners and you live in a community property state, then you can choose which of the two classifications you want to use.

If your LLC made an election, then your LLC is taxed as a C corporation or an S corporation.

Do you need to make an election for your LLC to be taxed as a C corporation or an S corporation?

This election is typically recommended for operating businesses that are profitable. This election is typically not recommended for LLCs that hold investments, such as stock or real estate. LLCs that hold investments are typically best left in their default classification.

When should your LLC make the election to be taxed as a C corporation or an S corporation?

Once you have determined your LLC needs to make the election, you then need to consider the rules of when the election can be made:

*General rule: The election can take effect up to 75 days prior to the date the election is filed and up to 12 months after the election is filed.

Example: An LLC files its election to be taxed as a corporation on October 15th. The effective date for the tax election can be as early as August 2nd (75 days prior to October 15th) or as late as October 15th of the following year or any date in between.

*Special rule: For newly formed LLCs, in most cases, the LLC can file the election as late the original due date of the first corporate tax return and the election is effective as of the first day of the LLC.

Example: An LLC is formed on October 1, 2007. The LLC files its election to be taxed as a corporation by March 15, 2008 which is the due date of the first corporate tax return. The effective date of the election can be as early as October 1, 2007.

Understanding the fundamentals of entities, particularly LLCs, is a key part of building a wildly successful tax strategy.