Many tax code–defined real estate professionals wonder if they can immediately use prior passive losses once they qualify for real estate professional status.
The short answer is no, and here’s why.
IRC Section 469 Background
IRC Section 469 limits your ability to deduct passive losses to offset non-passive income, such as wages, interest, and dividends.
The passive activity rules particularly impact real estate rentals, which are per se passive by default.
If you materially participate in a business, its income or loss is considered non-passive. But most rental losses remain passive, regardless of your involvement, unless you qualify for an exception.
Passive losses adhere to the following three principles:
Example. John, a doctor earning $500,000 annually in non-passive income, generates a $50,000 loss from his rental property in Year 1. He cannot offset this loss against his medical income due to the passive loss rules. In Year 2, he sells the property for a $100,000 capital gain. As a result:
Key point. For John to deduct the $50,000 loss in Year 1, he would have to (1) be a tax code–defined real estate professional who (2) materially participated in his rental property activity.
What Is a Tax Code–Defined Real Estate Professional?
The tax code real estate professional exception is Part 1 of a two-part solution that allows you to treat rental losses as non-passive. To qualify as a tax code real estate professional, you must
Special rule for employees. When counting real property work time for the 50 percent test and the 750-hours test, the W-2 employee must have more than a 5 percent ownership interest in the rental or other real property business.7 With 5 percent or less ownership, the work time counts as work time but not as rental or other real property trade or business work time.
The IRS defines “eligible real property businesses” as those engaged in8
Meeting the two requirements makes you a tax code–defined real estate professional. It’s the first step to making your rental activities non-passive.
But to deduct your rental losses against all your income, you must also pass Part 2 of the solution. Part 2 requires that you materially participate in your rental activities.
You can deduct rental losses against all income when you meet the two-part solution: Part 1 (the 50 percent test and the 750-hours test) and Part 2 (the material participation test).
Example. Debbie, a real estate broker earning $500,000 in non-passive income, incurs $100,000 in rental losses. Her real estate brokerage firm, which she owns, helps her pass the tax code–defined real estate professional test. She also passes the material participation test because she is the only person who works on the rentals. Accordingly, she deducts the $100,000 in losses against her non-passive brokerage income.
Former Passive Activities
What happens to prior passive losses from years before you qualified as a real estate professional?
Unfortunately, those losses remain passive. Real estate professional status applies to the current year only and must be tested annually.
Prior passive losses fall under the “former passive activity” rules in IRC Section 469.10 You can use the prior losses in three ways:
Example. John, our doctor from the example above, generates $50,000 in rental losses in Year 1; the tax code suspends them under the passive loss rules. In Year 2, when the rental activity incurs $60,000 in rental losses, his wife, Susan, (1) qualifies as a real estate professional and (2) materially participates in the rental activity. As a result:
Takeaways
Real estate professional status is not retroactive. Qualifying as a tax code–defined real estate professional does not free up prior suspended passive losses.
Annual testing is required. Real estate professional status applies on a year-by-year basis. To deduct rental losses against non-passive income, you must meet the 50 percent test, the 750-hours test, and the material participation requirement annually.
Prior passive losses remain subject to restrictions. You benefit from previous years’ passive losses when you
