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Thinking about becoming a landlord? There are a few things that you should know.

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There are a lot of different strategies that people pursue to build wealth, one of the most common is rental real estate. Rental real estate is attractive for various reasons, such as but not limited to:

  1. It is seen as low risk due to the fact that real estate generally appreciates in value over time.
  2. There are low barriers to entry, finding rental real estate is not difficult.
  3. Can generate positive cash flow exceeding taxable income.
  4. Ability to leverage initial investment capital allowing for larger investments.

Before investing in rental real estate, it is important to understand how this will impact your tax profile. Rental real estate is inherently considered a passive activity and because of this there are limitations in regard to deducting losses from these activities. Generally, the only way that passive losses are able to be deducted is if there is passive income and allowable passive losses are limited to the extent of the passive income. There are exceptions to this limitation though.

If a real estate investor is an active participant in the real estate activity, they may be eligible to take up to $25,000 of losses from the rental without having passive income. To be considered an active participant, the taxpayer only needs to be involved in making management decisions or arranging for others to provide services. Examples of management decisions meeting this requirement include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions. The special allowance for active participants is subject to an income phaseout of 50% if their adjusted gross income is in excess of $100,000 and is fully phased out if adjusted gross income is $150,000 or more.

There is another exception to the passive activity loss rules for taxpayers who meet the definition of material participation. To be considered a material participant, a taxpayer needs to satisfy at least one of the following tests during the year:

  1. Participate in the activity for more than 500 hours.
  2. Level of participation in the activity for the tax year was substantially all of the participation in the activity of all individuals for the year.
  3. Participate in the activity for more than 100 hours during the tax year and participated at least as much as any other individual, including those who do not own an interest in the activity, during the year.
  4. Materially participated in this activity for any 5 of the 10 tax years immediately preceding the current tax year.
  5. The facts and circumstances indicate the taxpayer participated in the activity regularly, continuously, and on a substantial basis during the year for at least 100 hours. Participation does not meet this requirement if any person except for the taxpayer received compensation for performing management services or any individual spent more hours during the tax year performing management services than the taxpayer.
  6. Participation in the activity is a “significant participation” activity for the year and you participated in all “significant participation activities” during the year for more than 500 hours. A “significant participation activity” is any trade or business in which you participated more than 100 hours during the year and in which you didn’t materially participate under any of the other material participation tests.

If any of these requirements are met, the passive activity loss rules do not apply for a rental real estate activity.

Related to the passive activity loss rules, taxpayers should be aware of the self-rental recharacterization rules when investing in real estate. It is common for taxpayers to own an operating company and to have related real estate within a separate entity for a variety of reasons. In these instances, the real estate company often charges rent to the related operating company. If net income exists from the related party self-rental activity, it is recharacterized from passive income to non-passive income but if a net loss exists it is still subject to the passive activity loss rules.

There are numerous tax implications that should be considered when investing in real estate in addition to the passive activity loss rules. If you are exploring real estate investment, BS&P CPAs and Consultants has a team of experienced advisors to assist in determining if this investment option aligns best with your individual investment goals.

Written by, Matthew Sova, Manager