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Under the general rules for rental real estate, losses are only deductible up to a maximum of $25,000 per year. In addition, this maximum deduction is reduced by 50% of the amount by which adjusted gross income exceeds $100,000, but not below zero. If the taxpayer is considered a real estate professional however, these passive loss rules do not apply. Losses can be deducted beyond the $25,000 regardless of income level.
A taxpayer qualifies for a particular tax year if:
... more than half of the personal services the taxpayer performs during that year are performed in real property trades or businesses in which the taxpayer materially participates, and
... the taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which he materially participates.
A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. The determination of a taxpayer's real property trades or businesses is based on all relevant facts and circumstances. Once a taxpayer determines the real property trades or businesses in which personal services are provided, he can't redetermine them later unless the original determination was clearly erroneous or there's been a material change of facts and circumstances.
Personal services means any work performed by an individual in connection with a trade or business, but not as an investor. Services performed as an employee don't count, unless the employee is a more-than-5%-owner of the employer.
A taxpayer who owns at least one interest in rental real estate and who meets the above tests is a qualifying taxpayer (commonly referred to as a “real estate professional”).
Spouses filing a joint return qualify only if one spouse separately satisfies the above tests without regard to the other spouse's services. A closely-held C corporation qualifies if more than 50% of its gross receipts for the tax year are derived from real property trades or businesses in which it materially participates.
These rules are applied as if each interest of the taxpayer in rental real estate were a separate activity. However, a taxpayer can elect (by filing a specified statement with taxpayer's original income tax return) to treat all interests in rental real estate as one activity. In other words, absent the election, each interest in rental real estate is treated as a separate activity. Thus, an owner of multiple rental real estate interests who fails to make the election must qualify with respect to each of those interests separately. The election makes it easier to meet the material participation requirement by allowing the taxpayer to aggregate his participation in all those activities. The election is binding for the tax year it's made and for all future years in which the taxpayer qualifies. Failure to elect in one year doesn't bar the election in a later year.
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