Tax law (and especially Section 469 of the Internal Revenue Code) mostly eliminates your ability to save big on taxes using real estate. That said, you do have a bunch of clever tricks available to deduct real estate losses on your tax return.
You just need to to plan ahead. And carefully structure your investing. But with little effort? You’d be surprised at the results.
Quick Review of Why Real Estate Produces Big Deductions
Let’s quickly review, though, how you can use real estate to generate big tax deductions.
Say you own a $1,000,000 property that generates $50,000 in rent. Further, suppose the property expenses, including the interest on the mortgage used to fund a part of the purchase, run $50,000.
You might assume such an investment breaks even for tax return purposes.
However, tax accounting rules will typically show a property like that described as losing money. Why? Because the investor depreciates the property.
Tax laws say investors can depreciate, or write off, the purchase price of a residential building over 27.5 years. And those same laws say a taxpayer can depreciate the purchase price of a commercial building over 39 years. (You only get to depreciate the building, not the land, by the way.)
And then the other wrinkle: Some of the bits and pieces of a residential property or commercial property can be written off much faster. Maybe in the year of your purchase.
A $1,000,000 rental property that breaks even, for example, might result in you putting a $100,000 or $200,000 deduction on the tax return you file the first year of ownership.
Which is why tax law includes the Section 469 passive loss limitation rules. In most situations, these rules say you don’t get to use big real estate deductions to shelter other income.
Exceptions exist for all rules, however. And more than a dozen exceptions allow you to deduct real estate losses or use real estate to shelter your other taxable income.
Real Estate Deduction Trick #1: Active Real Estate Participant
The first and easiest to use exception: The active participant exception (provided by Section 469(i)).
Specifically, if your modified adjusted gross income equals $100,000 or less, you can deduct real estate losses of up to $25,000 each year. The only two rules to make this deduction work are:
- You or your spouse need to own at least ten percent of the property.
- You or your spouse need to be actively participating in managing the property by doing things like picking the property manager, approving tenants and expenditures, and making rental agreement decisions.
By the way, if your modified adjusted gross income exceeds $100,000 but falls below $150,000, tax law proportionally phases out the $25,000 allowance. Someone with a modified adjusted gross income halfway between $100,000 and $150,000, for example, loses half of the $25,000 allowance.
The active real estate participant exception works for middle class taxpayers and for most upper-class taxpayers.
Note: Modified adjusted gross income equals a taxpayer’s adjusted gross income plus retirement deductions, passive losses such as on real estate, deductions for self-employment taxes, student loan interest, tuition deductions, and some foreign income deductions.
Real Estate Deduction Trick #2: The Section 280A(g) Exception
A weird trick works for property owners who also own a business structured as a corporation or a partnership.
A taxpayer in this situation can sometimes direct the corporation or partnership they own to pay rent to them for the use of a personally-owned real property.
If the rent counts as an ordinary and necessary expense, the rent payments get deducted on the corporation or partnership return. Which makes sense.
But here’s what’s weird. If the property owner rents the property for fourteen days or less, and then the property owner also personally uses the property for more than two weeks, the rent payments the taxpayer receives from their business don’t count as income.
An example shows how this works. You own a condo in Florida. When you attend a two-week industry conference in Orlando, rather than pay some hotel for lodging, your corporation pays you for using the condo for two weeks. (Say the corporation pays you $10,000.)
On the corporation’s tax return, the corporation counts the $10,000 as a valid deduction.
But on your individual tax return, the $10,000 rent received doesn’t count as income. Because of the Section 280A(g) rule.
By the way, the rental rate needs to be the market rate. (Accordingly, if the market rate is high, the rent amount can and must also be high.)
Real Estate Deduction Trick #3: Self-Rental
A related gambit works to deduct real estate losses, too.
If you buy property to rent to another trade or business you own, you can group the rental property trade or business with the operating trade or business on your tax return. That self-rental grouping lets you sidestep the passive loss limitation.
For example, if you run a professional practice (perhaps as an S corporation) and then you personally buy the building you use for the business, you get to deduct the real estate losses from the building on your personal return.
The one key bit of this rule to be alert to: The ownership of the rental property and the ownership of the operating trade or business need to match. Perfectly.
Note: We’ve got a longer and rather detailed discussion of how the self-rental trick works here: The Self-Rental Loophole.
Real Estate Deduction Trick #4: Real Estate Professional
Here’s a really powerful strategy to deduct real estate losses.
A real estate professional gets to deduct real estate losses if she or he materially participates in the rental operation.
To be a real estate professional, someone needs to spend more than 750 hours and more than 50% of their work day in a real estate trade or business they own (Section 469(c)(7)). Real estate trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, property management, learning, or brokerage.
And then, as noted, either the taxpayer or the spouse needs to materially participate in the rental business by spending enough time. (The standard, clean way to materially participate is to spend more than 500 hours on the investment property or properties in a year. But you can achieve material participation in other ways, too. Like by spending more than 100 hours a year if no one spends more time.)
An example shows the power of this strategy. Say a high income professional or executive earns $400,000 annually. Suppose his or her spouse manages a family real estate portfolio and in that role as a property manager qualifies as a real estate professional. Further suppose that the real estate portfolio produces real estate losses equal to $150,000. This married couple pays taxes on the net $250,000 in this situation. In other words, $150,000 of the household’s $400,000 annual income gets sheltered by the paper real estate losses.
Note: A longer discussion of how the real estate professional strategy appears here: How the Real Estate Professional Tax Strategy Works Also note that California prevents a taxpayer from using the real estate professional strategy for its state income tax returns. (A Californian still can use the real estate professional loophole to shelter federal income taxes.)
Real Estate Deduction Trick #5: Short-term Weekly-or-less Rentals
Here’s another strategy to deduct giant real estate losses.
If your average rental interval equals seven days or less, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(A)) says you’re not in the real estate rental business. Rather, you’re in a non-real-estate business. That means you get to deduct any of the non-real-estate losses if you materially participate.
Note: A longer discussion of how this real estate deduction exception works appears here: How the Vacation Rental Tax Strategy Works. But know that short-term rentals work really well as long as you carefully follow the rules.
Real Estate Deduction Trick #6: Short-term More-than-a-Week Rentals
Another similar, but less well-known, short-term rental exception applies, too.
If a taxpayer rents property for, on average, thirty days or less but more than a week and she or he provides significant personal services, tax law (in this case, Reg. Sec. 1.469-1T(e)(ii)(B)), says they’re also not in the real estate rental business. Rather, they’re in a non-real-estate business. If a taxpayer materially participates in the non-real-estate business? Bingo. They get to deduct real estate losses.
So for example, if someone operates a hotel and the hotel provides daily maid service, a front desk with bellhops, and then maybe a concierge, that’s not a real estate business. And the taxpayer gets to deduct any of the non-real-estate losses if she or he materially participates.
Sidebar: The IRS Definition of “Significant”
One caution here: The IRS says “significant personal services” means really significant. Here’s the example the Treasury regulations give for when personal services provided by a residential apartment hotel fail to reach the level of “significant:”
The taxpayer is engaged in an activity of owning and operating a residential apartment hotel. For the taxable year, the average period of customer use for apartments exceeds seven days but does not exceed 30 days. In addition to cleaning public entrances, exists (sic), stairways, and lobbies, and collecting and removing trash, the taxpayer provides a daily maid and linen service at no additional charge. All of the services other than maid and linen service are excluded services (within the meaning of paragraph (e)(3)(iv)(B) of this section), because such services are similar to those commonly provided in connection with long-term rentals of high-grade residential real property.
The value of the maid and linen services (measured by the cost to the taxpayer of employees performing such services) is less than 10 percent of the amount charged to tenants for occupancy of apartments. Under these facts, neither significant personal services (within the meaning of paragraph (e)(3)(iv) of this section) nor extraordinary personal services (within the meaning of paragraph (e)(3)(v) of this section) are provided in connection with making apartments available for use by customers. Accordingly, the activity is a rental activity.
So, daily maid service isn’t enough. A taxpayer needs more than that.
Real Estate Deduction Trick #7: Rental Incidental to Extraordinary Personal Services
Sometimes, the owner of a residential property or commercial building lets customers use the residential facilities or commercial property just as part the customer receiving some other service.
For example, a hospital or nursing home may in effect “rent” hospital rooms to patients. But the rental activity pales in comparison to the medical or nursing care the people receive.
Another example: A college or boarding school provides (so in effect “rents”) rooms in on-campus dormitories to students attending classes. But the real activity is education.
In these settings where extraordinary personal services are provided, tax law (specifically Reg. Sec. 1.469-1T(e)(ii)(C)) considers the activity a non-real-estate activity. And the taxpayer may deduct the non-real-estate deductions and losses if they materially participate.
Probably not an idea many people will use. But you never know.
Real Estate Deduction Trick #8: Rental Activity Incidental to Nonrental Activity
Another way exists to deduct real estate losses based on the incidental nature of the real estate, too.
Specifically, if a trade or business owns and rents property, but that rental activity is only incidental relative to the main trade or business? The losses connected to the rental property don’t get limited by the Section 469 passive loss limitation rules.
The current Section 469 regulations (at Reg Sec. 1.469-1T(e)(vi)) provide three examples of this sort of incidental rental activity. One example says that if the taxpayer holds the property for appreciation and the gross rental income is less than the lesser of two percent of either the unadjusted basis or the fair market value of the property, that counts as incidental. Another example says that renting property to an employee counts as incidental. Finally, a third example says that if a property is used in a trade or business the taxpayer owns an interest in and the gross rental income falls less than two percent of the lesser of property’s unadjusted basis or fair market value, that minuscule rental income counts as incidental.
This approach to deducting real estate losses probably won’t result in giant tax savings. But might produce some.
Real Estate Deduction Trick #9: Nonexclusive Rental Activity
Nonexclusive use of property doesn’t count as a real estate rental activity (per Reg. Sec. 1.469-1T(e)(ii)(E)).
Examples of this situation? The Treasury’s regulations talk about a golf course where, in one sense, the property owner rents the use of the course to golfers. But not exclusive use. So that works.
And then a crazy idea which I also think works. Suppose you decide to get into the amusement park business. And you set up a haunted house attraction that charges people an admission fee. Again in this example, the property owner in effect rents the use of the house through an admission fee. But again not exclusive use. So that should work.
In these nonexclusive-use situations, as long as the owner materially participates in the activity, she or he can deduct real-estate-y losses.
Real Estate Deduction Trick #10: Insubstantial Rental Activity
The Regulations for Section 469 describe rules taxpayers can use to group activities. For example, a barber with two barber shops might treat the two shops as two activities. Or he might group the two barber shops into a single activity.
Normally, though, taxpayers can’t group rental activities with a nonrental activity.
But except for that special rule, most grouping rules apply common sense. Stuff a taxpayer would logically think of as one trade or business can be grouped. (The specific rules appear at Reg. Sec 1.469-4 but talk about similarities and differences in the businesses, the extent of common control and ownership, geographical locations, and then interdependencies between the activities.)
However, these grouping rules also flag a couple of other interesting possibilities that effectively allow a taxpayer to deduct real estate losses by clever grouping. For example, a taxpayer might (per Reg. Sec. 1.469-4(d)(1)(i)(A)) group an insubstantial rental activity with another trade or business. And then in effect deduct real estate losses.
The now-expired former Reg. Sec 1.469-4T provided a less than “20 percent of the activity’s income” threshold for determining insubstantial-ness. In an example the regulations provided, a law firm earned 90 percent of its gross income from practicing law and 10 percent from renting out two floors in the ten-story office building it owned and operated out of. That example said the two floors of rental activity counted as insubstantial.
But note what happens in this case: The taxpayer probably does get to deduct real estate losses in situations where an insubstantial rental occurs.
Tip: If you need to explore this possibility in more detail, read the Technical Advice Memorandum 200014010. It describes why the less than 20 percent approach shouldn’t be considered a “bright line” test.
Real Estate Deduction Trick #11: Insubstantial Nonrental Activity
The other example of insubstantial-ness occurs when an insubstantial non-rental activity gets grouped with a rental activity. In that situation, income from the insubstantial non-rental activity might allow a taxpayer to deduct real estate losses equal to the income from the insubstantial non-real-estate activity.
For example, a building owner starts a small coffee shop in the lobby of an apartment house she owns. Those two activities might be group-able based on georgraphy, common ownership and control, and then interdependencies. Further, if they are group-able and the coffee shop activity is insubstantial, it’s income may be netted with the apartment house losses. That means the taxpayer shelters active trade or busienss income using real estate losses.
Tip: Another tip for taxpayers or tax accountants who want to explore in more detail grouping real estate with insubstantial non-real estate activities: look at the Glick v. United States federal district court case.
Real Estate Deduction Trick #12: Other Passive Income
A twelfth way to deduct real estate losses: You get to deduct the passive losses you incur on an investment property to the extent you have passive income. And you may unlock past suspended passive losses.
For example, if your tax return will report a large $1,000,000 passive gain on the sale of one rental property, Section 469(d), so the actual law, essentially says that gain can be sheltered by $1,000,000 of suspended passive losses you’ve incurred in the past. And it can be sheltered by large passive losses you intentionally orchestrate for the current year. So that’s another way to deduct real estate losses on your return.
Real Estate Deduction Trick #13: Disposition of the Activity Generating Passive Losses
A final way to deduct real estate losses exists: You do get to deduct passive losses generated in some activity when you dispose of the activity.
For example, if over the years your tax returns have shown passive losses accumulating on a rental property, selling the property will typically unlock those losses.
Say you bought a property for $1,000,000, for example, wrote off $500,000 of the purchase price through depreciation deductions, and will now sell the property for $500,000. And say the rental income and rental expenses equaled each other. So, the property essentially broke even before considering the depreciation deductions.
A sale in this situation will unlock the previously suspended losses.
As always, taxpayers want to discuss a strategy like this with their tax advisor.
But this plug for our CPA firm: If you don’t have a tax advisor who can help? Please consider contacting us: Nelson CPA.