At Saba Tax Advisory, we understand the complexity of tax regulations and the importance of maximizing savings for our clients. One area where this is particularly relevant is in the realm of the Passive Activity Loss (PAL) rules.
The PAL rules, put in place by the IRS, limit the ability of taxpayers to use losses from passive activities to offset income from other sources. A passive activity is defined as any trade or business in which the taxpayer does not materially participate. This includes rental properties, limited partnerships, and certain types of investments. In order to claim a loss from a passive activity, a taxpayer must first pass a material participation test. If the taxpayer does not pass this test, the loss from the passive activity is limited to the amount of income generated by the activity. These rules are particularly relevant for real estate professionals, as rental properties are considered passive activities.
Example Of How The Passive Active Loss (PAL) Rules Apply
An example of the Passive Activity Loss (PAL) rules in action is a taxpayer who owns a rental property that generates a loss of $100,000, through depreciation deductions. If the taxpayer does not qualify as a real estate professional under the PAL rules, they would be limited to deducting up to $100,000 of that loss only against other passive income they may have, such as other rental income. However, if the taxpayer is considered a real estate professional under the PAL rules, they would be able to deduct the full $100,000 loss against not only passive income but also other income, such as W-2 wages or self-employment income, potentially reducing their overall tax liability. In this scenario, the passive activity loss rules limits the tax benefits for the person who is not qualified as a real estate professional.
Keep in mind, any passive loss in excess of passive income is suspended and can be carried forward indefinitely to offset future years’ passive income. This means that if a Cost Segregation Study was performed on the building and the excess depreciation deductions exceeded all passive income, you can carry the loss forward to offset income next year. You can do this until the loss has been completely used. If the entire interest in a passive activity is disposed of in a transaction with an unrelated party where a gain or loss is recognized, the suspended passive loss becomes fully deductible.
The passive activity rules impose certain limits on the amount of passive losses you can deduct against your ordinary income (such as W-2 wages). If your modified adjusted gross income (MAGI) is $100,000 or less, you can deduct up to $25,000 in passive losses. The deductibility of passive losses gradually reduces as your MAGI exceeds $100,000. For every $2 increase in MAGI above $100,000, the deduction is reduced by $1 until your MAGI reaches $150,000, at which point the deduction is fully phased out. These limits apply to both individuals filing as single or married filing jointly.
In order to claim losses against your ordinary income, you must demonstrate active participation in the activity. Active participation entails having a role in making management decisions for the business. This requirement is less stringent than the material participation criteria applicable to real estate professionals, which is discussed separately below.
For instance, if your MAGI is $100,000 and your rental properties generate a net loss of $30,000, you can deduct $25,000 of this loss against your ordinary income as long as you materially participate in the rental activities. The remaining $5,000 will be carried forward to future years.
However, if your MAGI is $125,000, the deductible amount of the loss is reduced to $12,500. Each dollar over $100,000 reduces the deduction by $0.50. If your MAGI exceeds $150,000, you cannot deduct any of these losses against your ordinary income, and the entire $30,000 loss is carried forward to be used in future years.
What Does It Take To Be Considered A Real Estate Professional (REP)
To be considered a real estate professional under the PAL rules, a taxpayer must meet certain criteria.
The first criteria is that the taxpayer must spend more than half of their working hours in the real estate industry. This includes activities such as managing rental properties, dealing in real estate, and developing or renovating properties.
The second criteria is that the taxpayer must spend more than 750 hours per year in real property trades or businesses in which the taxpayer materially participates. This includes activities such as managing rental properties, dealing in real estate, and developing or renovating properties.
The third criteria is that the taxpayer's participation in the real estate industry must be regular, continuous, and substantial. This means that the taxpayer's involvement in the real estate industry must be more than a sporadic or occasional activity.
Additionally, a taxpayer can be considered a real estate professional if they meet the above criteria for any five of the last ten years.
It's important to note that the IRS considers the above criteria on a case-by-case basis, and it's ultimately up to the IRS to determine if a taxpayer qualifies as a real estate professional.
In conclusion, the Passive Activity Loss (PAL) rules limit the ability of taxpayers to use losses from passive activities to offset income from other sources. To be considered a real estate professional under the PAL rules, a taxpayer must meet certain criteria, including spending more than half of their working hours in the real estate industry, spending more than 750 hours per year in real property trades or businesses in which the taxpayer materially participates and having regular, continuous, and substantial participation in the real estate industry. At Saba Tax Advisory, we can help you understand and navigate the complex PAL rules to help you maximize your tax savings.
The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.