Knowing What Counts Podcast

From Passive to Powerful: Unlock Your Real Estate Tax Benefits

• Tim Provost, CPA • Episode 7

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What Is The Difference Between Passive And Non-Passive Rental Income?

The complex world of real estate taxation contains hidden opportunities that could dramatically impact your bottom line—if you know where to look. Brian Moss, a senior tax associate with MP CPAs who recently passed all four parts of his CPA exam, breaks down the critical distinction between passive and non-passive rental income classification that every property owner needs to understand.

Most property owners don't realize that rental income defaults to passive status, severely limiting how losses can offset other income sources. Brian walks us through exactly what it takes to potentially reclassify your rental activities as non-passive, unlocking significant tax advantages. He details the dual requirements of material participation (requiring regular, continuous involvement) and real estate professional status (demanding more than 50% of your personal services and 750+ annual hours in real property businesses).

Whether you're a seasoned real estate investor or considering your first property purchase, this episode delivers actionable insights that could potentially save you thousands in taxes through proper planning and documentation. 

To learn more about MP CPAs visit:
https://thempgroupcpa.com/
MP CPAs
413-739-1800

Speaker 1:

Welcome to the Knowing what Counts podcast, the place where expert guidance meets smart financial decisions. Whether you're a high net worth individual or a thriving business, the experts at MPCPAs are here to help you protect and optimize your wealth. Let's get started, because success begins with Knowing what Counts. Because success begins with knowing what counts.

Speaker 2:

Unlock expert accounting insights tailored for real estate professionals with Property Pioneers, helping you optimize finances and maximize profits. Welcome back everyone. I'm Sofia Yvette, co-host slash producer, here in the studio today with real estate professional Brian Moss, a senior tax associate with MP CPAs. Brian, how's it going?

Speaker 3:

I'm doing pretty good, thank you. How about yourself?

Speaker 2:

I'm doing well. So, brian, tell us a bit about yourself.

Speaker 3:

Absolutely so. I've been working with MP since the beginning of 2022. I started off as an intern while I was finishing up my undergrad at Western New England University. Then I jumped right in here full time after that. While I've been here, I've been pursuing my CPA license. I just recently found out that I've passed all four parts of the exam, so it's exciting, from this point on, to be working towards getting the required credits to finish up my licensure, and I think, while I've been here, it's been a great opportunity to learn a lot, and I'm happy to have a chance to share some of that, what I've learned, with everybody who's listening today.

Speaker 2:

Well, that is great news. So, brian, what can you tell us about the standard rules for reporting rental activity on your tax return?

Speaker 3:

So for the standard rules for reporting rental activity on your tax return, by default rental activity is considered a passive activity. Just to give a little brief explanation of the comparison between passive versus non-passive Passive activity is mainly derived from activities that you don't really have any real active involvement in. Maybe you just make an investment in that business that entitles you to some of the profits, and rental activity is one type of activity that is by default considered passive. The tax treatment for rental activity and other passive activities is if you have passive losses, you can only deduct those losses on your return to the extent that you have passive income from other sources to offset that. So if you hypothetically would own multiple rentals, you can only deduct your rental losses from one property with the rental income that you have from a different property. Non-passive activity, on the other hand, doesn't really have that same type of limitation where you need non-passive income from other sources to offset it. You're able to deduct non-passive losses a little bit more freely than you can with passive.

Speaker 2:

So, brian, are there any ways to allow rental activity to be treated as non-passive?

Speaker 3:

Yes, there are some ways to change the tax treatment of your rental activity from passive to non-passive. There are really two big parts to the puzzle here, the first one being you need to have what's called material participation in the activity. That is a bit of a higher standard than simply having active participation, which you can achieve by just being involved in some of the management and decision-making types of activities with your rental property. For material participation that's required, there needs to be more regular, continuous and substantial involvement in that activity. There are, I think, seven different tests you can kind of look at to see to make sure that you're meeting the standard of material participation. You don't need to meet all seven. As long as you can meet one you should be set.

Speaker 3:

I'm not going to list all seven right now, but to name a couple that people with rental activity will sometimes try to reach for. If you participate in the activity for more than 500 hours during the year, that's a fairly common one. And another test you could look for is having your participation constitute substantially all participation of all individuals. So essentially, if you're the one doing most or all of the work towards your activity, then that would be a way you could meet that test. The material participation is one part of the equation and the other is meeting the IRS standards of being a real estate professional, which I think we're going to be discussing that a bit more today as well. But they have some pretty strict rules to get to that real estate professional standard.

Speaker 2:

What can you tell us about the requirements needed to qualify as a real estate professional? Let's get into it a little more.

Speaker 3:

Absolutely so. In order to be qualified as a real estate professional in the eyes of the IRS, there are two tests that you must satisfy. In this case, you have to meet both of them. You can't just pick one. The first test is that more than 50% of your personal services must be in real property business. The other test is that more than 750 hours per year must be spent in real property business.

Speaker 3:

The second test there is typically not quite as challenging for people to meet compared to the first one. That first one can be especially hard to get to if you also have another full-time job outside of rental activities, if you have a job where you work 40 hours a week that's not related to your rentals. In order to meet that first test, you must also be able to prove that you are putting in over 40 hours a week towards the rental activities to meet that one, and that's kind of a hard sell for the IRS. They haven't really found that to be very believable in a lot of cases in the past. That being said, though, there are some professions and jobs out there that can count towards the hours needed to meet these two tests.

Speaker 3:

Essentially, any job that you work in that is related to real estate, development, construction management, leasing, working as a real estate broker or agent the hours you spend there can count towards these two tests. The one caveat for that, though, is you must be working as an independent contractor or sole proprietor in one of these professions. If you're simply an employee working in a career like this, you must own at least 5% of the business to count this time towards the real estate professional tests. There are a few types of rental and real estate related activities that do not count as hours spent towards these two tests, that people don't always know about, so those are time spent with real estate investing, traveling to and from your rental properties and time spent researching topics related to real estate and rentals and need. Hours spent there cannot apply towards these two tests.

Speaker 2:

Wow. What records or support should people maintain as proof that they meet the two real estate professional tests?

Speaker 3:

So for the two real estate professional tests it's pretty strict on what kind of documentation you need. It's really important that you maintain contemporaneous documentation that's recorded at the time you're performing it. Anything that's kind of a little bit more like ballpark estimates or after the fact, the IRS has not really found that to be sufficient to prove you're meeting the real estate professional standards in the past. So it's vital that you keep time logs that reflect the hours in which you're performing services. That also means that goes towards only hours that you are actually performing work, simply being on call or available if you're needed at a property. Time spent like that cannot really count towards the real estate professional tests.

Speaker 2:

And so how do these rules apply to people who own multiple rental properties?

Speaker 3:

rental properties. So, for someone who owns multiple rental properties, the default rule is that you must meet the real estate, professional and material participation standards for each property separately. If you own a lot of properties, that can be pretty hard to do, and only the properties that you actually meet those tests for are the ones that would get that non-passive treatment. That being said, though, you have an option to make an election with your tax return to group all of your rental properties together into one single economic unit or one single activity, and as long as that election is made, then all of the time spent throughout all of your properties can come together and apply to meeting the tests for that one activity that you've grouped them all together, as on your return. So that could certainly be a potentially advantageous strategy to consider when filing your return if you own multiple properties.

Speaker 2:

So can someone who hires the services of a real estate management company still meet the real estate professional status? Someone who hires a real estate management company still meet the real estate professional status?

Speaker 3:

Someone who hires a real estate management company can still meet that real estate professional status. It can be a little bit trickier, and it all comes down to making sure that you have the proper documentation to substantiate that you are still the primary person involved in managing the day-to-day operations of the company. You are still substantially involved in everything that's going on and you're not simply just checking off or approving decisions that the management company is making for you. So you're going to want to make sure that you have it laid out very clearly. These are the things that I am doing and I'm responsible for, versus these are the things that the management company is doing and what they are responsible for. So this needs to be very clear that you're not just handing off the reins to them and letting them take control of everything for you.

Speaker 2:

What are the most common mistakes people make when trying to qualify as a real estate professional?

Speaker 3:

So a lot of the most common mistakes typically all come back to not having enough supporting documentation to prove you're actually meeting all of these pretty strict tests that they put forward. Related to that was a case back in 2019, harrison v Commissioner where in that scenario, there was a married couple that was filing as real estate professionals on their tax returns and taking all of their rental activity as non-passive rather than passive. The court ended up ruling against them being able to do that, saying that neither spouse alone was able to prove that they had met the real estate professional status tests or the material participation tests. The rules surrounding that are that if you are filing a joint return with the spouse, at least one spouse on their own must put in enough hours to meet the real estate professional standards. You cannot pool together the hours of both spouses to get that treatment.

Speaker 3:

What's interesting here is that in this case, the married couple did have pretty clear records showing what work was performed, how long they spent doing it.

Speaker 3:

What they failed to do was have any clear specification as to which spouse was performing which task, so there was a lot of uncertainty whether one of them alone was putting in enough hours to meet the tests, kind of to make matters worse for them too.

Speaker 3:

The courts had also determined that the calendars and records they had kept did not accurately reflect the hours of activity performed. There were a lot of cases where they had recorded a full hour for performing some trivial tasks that don't really take an hour to do, such as spend a full hour just receiving payments or paying a mortgage stuff that really only takes a couple minutes. They would put a full hour spent doing it. So it was kind of the impression that they may have been inflating some of their hours a little bit. And then another mistake that they had made, unfortunately for them, was that they had reported a lot of hours towards simply watching contractors perform their work, which, as we were discussing earlier, the time spent to meet the real estate professional and material participation tests have to be work that you are actually actively performing. Simply being on call or available or supervising in this case is not really enough to cut it to meet those hours.

Speaker 2:

Wow. Any final thoughts or comments?

Speaker 3:

Sure. So, as we've been discussing, it is pretty tough in some cases to qualify for these tests, with how strict the IRS really gets about verifying whether or not you meet the real estate professional standards. In the event that you may not be able to meet these tests but still want to find a way to treat your rental activity as non-passive, there is another option you could consider, which would be to operate your rental business as a short-term rental. In that case, that essentially just means that the average stay of your tenants is seven days or less, although, to get non-passive treatment with this method, you would still need to have the material participation element present there.

Speaker 2:

Love it, Brian. We'll catch you on the next episode. Have a fantastic rest of your day.

Speaker 3:

Thank you, you do the same.

Speaker 1:

Thanks for listening to the Knowing what Counts podcast. Ready to optimize your wealth and protect your future, visit the mpgroupscpacom or call 413-739-1800 to connect with our team of experts. Remember, success is about knowing what counts.