Overcoming the Tax Pitfalls of Real Estate Development and Investment.

By Eric Budreau, CPA, MT, Senior Tax Manager, Gordon, Hughes & Banks, LLP

With the volatility of the stock market and a desire to diversify investment portfolios, individuals are increasingly purchasing real estate as an investment and income vehicle. It is rare in Colorado to not know someone involved in real estate: either as a developer/investor or ‘weekend dabbler.’ For the inexperienced, real estate investment can be a minefield when tax consequences or tax planning opportunities are overlooked.

When real estate is purchased with the intention of renting, Internal Revenue Code (“I.R.C.”) §469 applies. From a tax perspective, rentals, even if providing the purchaser with positive cash flow, will tend to generate a tax loss due to the depreciation of the property. Prior to the enactment of I.R.C. §469 by the Tax Reform Act of 1986, this loss was fully deductible. Now, the loss is subject to the “Passive Activity Loss” rules.

Passive activity losses are disallowed in the calculation of current taxable income to the extent they exceed passive activity income. “Passive activity means “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” In contrast, material participation implies the taxpayer actively participates in a significant and ongoing basis. To further complicate the situation, the rules specifically define “any rental activity” as a passive activity, regardless of the participation in the activity.

The tax law contains an exception to the deductibility of losses generated from the rental of real estate. Generally, $25,000 of losses may be deductible from rental real estate activities with respect to individuals who “actively participated” in the rental activity, regardless of whether there is passive activity income to offset losses. This provision is then “phased out” based on the income levels of the taxpayer. The benefit is reduced by 50 percent of the amount by which the Adjusted Gross Income of the taxpayer for the taxable year exceeds $100,000. Accordingly, the benefit is fully phased out when the taxpayer’s Adjusted Gross Income reaches $150,000.

So, depending on an individual’s tax situation, the losses incurred on real estate rentals may be suspended, and the taxpayer may not reap the tax benefit of the loss until a future date; thereby reducing the investment’s overall return on investment.

What then are the alternatives? An often overlooked provision is the special rule for taxpayers in real property businesses [I.R.C. §469(c)(7)]. Under this provision, certain real estate losses of “Real Estate Professionals” are exempt from classification as passive activities. Taxpayers who meet the requirements may be able to deduct otherwise deferred rental real estate losses as current year business losses. In order for this exception to apply, the taxpayer must satisfy the following two tests:

1. For the applicable tax year in question, the taxpayer must have performed more than one-half of his or her personal services in real property trades or businesses in which the taxpayer materially participates.
2. The taxpayer must have performed more than 750 hours of services in real property trades and business.

Many advisors incorrectly believe that this rule applies only to real estate agents who own rental real estate. The rules specifically identify personal services in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or businesses for the purposes of defining the term “real property trade or business”. Nothing in the provision specifically states or requires that the individual hold a real estate license. Regarding the 750 hour requirement: for a married individual filing a joint return, only one spouse can fulfill the hourly requirement.

Additionally, the courts have required that contemporaneous documentation be compiled and maintained in order to establish the qualification of the taxpayer as a real estate professional. Although still unclear as to the desired format, certain forms may be acceptable, such as appointment books, calendars, narratives, etc.

1. Under this provision, each of the qualifying taxpayer's entities is treated as a separate entity for the more than 750 hours of services, unless the taxpayer formally elects to treat certain interests as a single activity. Exercise care when making such election as it may produce other undesired tax consequences.
2. Depending on the choice of entity for your venture, the rules may or may not apply; so consult your tax professional.
3. Where rental activities have suspended losses due to being previously characterized as a passive activity, suspended losses may not be reclassified. They remain passive and may only be utilized against future passive activity income, subject to the $25,000 exception on a go forward basis, and/or conveyed in a taxable transaction of the property.

The National Association of Realtors recently reported that U.S. citizens are increasingly investing in rental real estate because of rising interest rates which limit home ownership, and thus increase demand for rental properties by young adults who are just forming households. As individuals purchase rental properties for investment, it is imperative to understand the often confusing tax implications of ownership as promulgated by the 1986 Tax Reform Act and IRC 469. Creating a Real Estate Professional entity is one option for developers and investors to overcome potential losses and reap expected benefits.

This article appeared in the December 15, 2006 issue of The Denver Business Journal.