Many construction contractors faced large losses in 2008, and many may face the same scenario in 2009. Some of the losses are from rental real estate—and those losses normally can’t be deducted in the tax year they occur because the Internal Revenue Service (IRS) treats rental real estate interests as “separate activities” and “passive investments.” If they generate losses, taxpayers must suspend, or carry forward, the losses to a future tax year.
While contractors watch cash reserves decline, they’re being saddled with losses they can’t deduct for a while.
But for qualified real estate professionals, the IRS provides two ways to deduct rental losses right now.
- A real estate professional can deduct rental real estate losses as an ordinary deduction in the current tax year.
- If losses exceed gains in the current year, a real estate professional can “carry back” the net loss to an earlier year, subtract it from profits and receive a tax refund.
To take advantage of this opportunity, business owners must first qualify as real estate professionals. To do so, owners must materially participate in a trade or business that develops, constructs, acquires or converts, rents or leases, manages or operates, or brokers real property. They also must perform more than 750 hours of service and spend more than half their time in this trade or business during the tax year.
Aggregate Real Estate Interests for Tax Purposes
To deduct rental losses in the current tax year and carry them back to an earlier year, real estate professionals must elect to aggregate their real estate interests on their tax returns.
To deter tax shelter schemes, Congress forces taxpayers to “materially participate” in an activity in order to deduct losses generated from that activity. But when rental real estate activities are analyzed on an activity-by-activity basis, it’s often difficult to satisfy the material participation thresholds.
Business owners are considered material participants in an activity if they meet any one of the following tests:
- they participate in the activity for more than 500 hours in the taxable year;
- their participation constitutes substantially all participation from all individuals in the activity; or
- their participation is more than 100 hours, while no other individual participates more than 100 hours.
Electing to aggregate various rental real estate interests as a single activity for tax purposes makes it easier for real estate professionals to meet these material participation standards.