Investing in real estate can be lucrative, but it also comes with tax implications. Recently, New York State has been sending questionnaires to taxpayers who claimed significant real estate losses in 2020. This need to collect more information comes as the statute of limitations will soon run out for 2020 tax returns.
The questionnaire aims to determine if the taxpayer is considered a real estate professional and, therefore, can deduct losses from real estate activities against their ordinary income. It also establishes whether income or gains from real estate activities are subject to the net investment income tax.
Taxpayers with other large incomes, such as salaries and wages, are being targeted for the questionnaire. It asks for documentation to support real estate losses claimed on the return. The questionnaire is looking for additional support to justify the real estate losses claimed. If the support provided is insufficient, it could rise to the level of an audit. To fill out the questionnaire effectively, one must first understand how to qualify as a real estate professional.
Passive vs. Active Earning Activity
Real estate earnings are usually considered passive, limiting any losses to passive income. A passive activity is when a taxpayer does not materially participate in a trade or business activity used to generate income or loss. Passive loss regulations, which the IRS sets, prohibit taxpayers from using passive losses to offset earned or ordinary income. Any disallowed losses would carry forward until the taxpayer has passive income or the property is sold.
Real estate activity can be considered active if a taxpayer meets certain qualifications, including making management decisions or arranging for others to provide services. No specific hours are required to qualify, and substantial involvement is not needed. The taxpayer can deduct up to $25,000 of losses as long as their adjusted gross income is between $100,000 and $150,000 for those who are married and filing jointly.
Qualifying as a Real Estate Professional
Real estate professional status allows all losses to be taken in the year incurred. There is no passive loss limitation, and your activity is not subject to the net investment income tax.
To qualify as a real estate professional, the taxpayer must perform more than half of their total personal services in real property trades or businesses in which they materially participate. To determine a taxpayer’s material participation, they must qualify for one of seven tests, as the IRS explains.
The taxpayer must also spend more than 750 hours participating in real estate business activities during the tax year. The 750-hour rule includes all of the taxpayer’s real estate activities. Real estate activities are more than just rental activities; they include any real property development, redevelopment, construction management, leasing, acquisition, brokerage trade, or business.
The 750-hour rule needs to be proven for each property and activity unless a grouping election is made. Grouping elections are irrevocable and must be made each year a new activity is added to the group. Suppose there are any properties within the grouping election with passive loss carryovers. In that case, they are not released when the property is sold unless substantially all of the group is disposed of.
A taxpayer must qualify for both material participation and the 750-hour rule without considering their spouse’s activities. However, a spouse’s activities can be used to meet one of the seven material participation tests.
Qualifying for real estate professional status does not release any passive losses from previous years. Those are still carried forward and claimed when the taxpayer has passive income.
When claiming real estate professional status, make sure to keep important records, including daily time reports, labor logs, appointment books, and calendars.
If real estate professional status was claimed to allow for a significant loss to be taken, New York State is currently requesting the following information on the questionnaire:
- Records proving 750 hours were spent in the given year
- A copy of the grouping election
- A description and total hours spent working any job not related to real estate (if applicable)
- Whether a property manager was utilized for rental properties
- Whether any of the properties were sold during the year in question
RDG+Partners has experience assisting our clients with these questionnaires and any potential audits. If you have any questions or think your tax returns could generate one of these questionnaires, contact us at 585-673-2600. We are happy to help.