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Real Estate Investors: Can You Turn “Pro”?

Savvy real estate investors know all about the passive activity loss (PAL) rules. In general, losses from passive activities, such as rental real estate, are limited to annual passive activity income. However, if you can qualify as a real estate professional, you are effectively exempted from these rules.

In other words, a real estate professional can deduct rental real estate losses against highly taxed ordinary income from other sources—not just passive income. To qualify, you must spend more than half of the time performing personal services as a material participant in real estate businesses and at least 750 hours during the year materially participating in real estate activities. As a new case shows, taxpayers are required to prove regular, continuous and substantial involvement in the activities.

Facts of the case: A taxpayer owning five rental properties claimed that he qualified as a real estate professional. However, he was unable to establish a contemporaneous record—other than his own testimony, “guesstimates” and vague affidavits—that he had spent enough time working as a material participant in real estate. Despite the taxpayer's claim of extenuating circumstances that hindered his recordkeeping efforts, the Court rejected the claim.

If you are not a real estate professional, but you “actively participate” in a rental real estate activity, you may still deduct up to $25,000 of losses against nonpassive income. This special offset is phased out for high-income taxpayers.

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