Differences Between Active and Passive Investors in Real Estate
Definitions
Active Investors: Active investors in real estate are those who are significantly involved in the management and operations of their properties. This includes activities such as making decisions about property improvements, tenant selection, and day-to-day management. Active investors often qualify as real estate professionals under the Internal Revenue Code (IRC) § 469, which allows them to deduct losses from their real estate activities against other types of income.
Passive Investors: Passive investors, on the other hand, are those who invest in real estate but do not materially participate in the management or operations of the properties. Their involvement is limited to providing capital and perhaps some oversight, but they do not engage in the regular, continuous, and substantial activities required to be considered active participants.
Tax Implications
Passive Activity Loss Rules: Under IRC § 469, passive activity losses (PALs) are generally not deductible against non-passive income, such as wages or active business income. Instead, these losses can only offset income from other passive activities. If passive losses exceed passive income, the excess losses are carried forward to future years until they can be used to offset passive income or until the property is disposed of in a taxable transaction.
$25,000 Offset for Active Participation: IRC § 469(i) provides an exception for individuals who actively participate in rental real estate activities. These individuals can deduct up to $25,000 of passive losses against non-passive income. To qualify, the taxpayer must own at least 10% of the rental property and be involved in management decisions, such as approving new tenants and setting rental terms. This deduction is subject to a phase-out based on adjusted gross income (AGI).
Phase-Out Rules Based on AGI: The $25,000 offset begins to phase out when a taxpayer’s AGI exceeds $100,000 and is completely phased out at an AGI of $150,000. The phase-out reduces the $25,000 allowance by 50% of the amount by which the taxpayer’s AGI exceeds $100,000.
Criteria for Qualifying as a Real Estate Professional
To qualify as a real estate professional under IRC § 469(c)(7), a taxpayer must meet two main criteria:
- More than 50% of Personal Services: More than half of the personal services performed by the taxpayer in trades or businesses during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates.
- 750-Hour Requirement: The taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which they materially participate.
If these criteria are met, the taxpayer’s rental real estate activities are not automatically considered passive, and losses from these activities can offset other types of income.
Examples and Relevant Case Law
Example 1: John is a full-time real estate agent who spends over 1,000 hours a year managing his rental properties. He meets both the 50% personal services and the 750-hour requirements, qualifying him as a real estate professional. Therefore, his rental losses can offset his other income, such as commissions from real estate sales.
Example 2: Sarah owns a rental property and is involved in making management decisions but does not spend more than 750 hours a year on these activities. She qualifies for the $25,000 offset for active participation, but her AGI is $120,000. The phase-out reduces her allowable offset by $10,000 (50% of the $20,000 excess over $100,000), leaving her with a $15,000 offset.
Case Law: Conner, Barry G. et ux. v. Commissioner: In this case, the taxpayers, Barry and Bridget Conner, were involved in various real estate activities through limited liability companies (LLCs). The Tax Court and the Eleventh Circuit Court of Appeals held that the Conners’ losses from their LLCs were limited under IRC § 469 because they did not materially participate in the activities. The courts emphasized the importance of meeting the material participation requirements to avoid the passive activity loss limitations.
Case Law: Langille, Deanna v. Commissioner: Deanna Langille was involved in both a law practice and real estate activities. The Tax Court found that she did not qualify as a real estate professional because she did not meet the 50% personal services or the 750-hour requirements. Consequently, her rental losses were considered passive and could not offset her non-passive income.
Conclusion
Understanding the differences between active and passive investors in real estate is crucial for tax planning and compliance. Active investors who qualify as real estate professionals can benefit from more favorable tax treatment, including the ability to offset rental losses against other income. Passive investors, however, are subject to the passive activity loss rules, which limit the deductibility of their losses. The $25,000 offset for active participation provides some relief, but it is subject to phase-out based on AGI. Case law, such as Conner, Barry G. et ux. v. Commissioner and Langille, Deanna v. Commissioner, illustrates the application of these rules and the importance of meeting the material participation requirements.
Author of this article Jack Chaudhary specializes in Individual, Corporate Tax returns, Foreign Taxes, Expats, Non-resident Taxes, Payroll, Crypto and e-Commerce. With the Enrolled Agent credential, Jack represents taxpayers before the IRS and state taxing authorities. He zealously advocates for his clients to ensure the best results are achieved. Book an appointment here with him for a consultation call.
