(Art Credit: Karen Fischer)

Here’s What You Need to Know About Related Losses

Many self-employed individuals and freelancers invest in rental real estate properties to supplement their income or even get their real estate license to do the same. If you’re one of them, it’s important to understand how potential losses may impact your taxes.

Understanding how the IRS treats rental property income and losses is key.

First a definition. The Internal Revenue Service (IRS) defines a rental property as “any transfer of property for compensation.”  This could include transactions such as those involving Airbnb, Vrbo, single family homes, townhomes, condominiums, and apartments, to name a few.

When it comes to real estate income from a tax perspective, you must include the income as on your return. Rental proceeds are not subject to the 15.3% self-employment taxes and are taxed as regular income at your effective tax rate.

However, for the typical rental property owner, it is not uncommon for properties to result in a net loss for tax purposes thanks to operating expenses and depreciation.  The treatment of these net losses is typically misunderstood so let’s clear it up here:

As a rule, losses from rental property are considered passive losses, for tax purposes, and generally can only be offset against passive income. Passive income/loss is derived from income producing activities in which one does not materially participate in.

If passive losses exceed passive income, in general, passive losses are suspended and carried forward indefinitely to future years to offset passive income.  However, if the property is sold and suspended losses still exist the passive losses become realized and are applied against the sale proceeds.

It is possible for passive losses to offset ordinary income, if you can demonstrate active participation in the activity.  For tax year 2022, you can deduct up to $25,000 in passive losses against ordinary income if your modified gross income is $100,000 or less.

Freelancers who are real estate professionals must be aware of these tax rules.

If you are a real estate professional, you will have a more stringent definition of active participation.  The term “real estate professional” is defined for tax purposes this way:

• Material participation – you spend at least 750 hours in a real estate trade or business, and
• More than half your total working hours must be in a real estate trade or business.
• For those that are real estate agents and investors, material participation can’t be combined between both activities.
• If more than one rental property is owned, material participation is separately determined for each rental property, unless an election is made to treat all real estate interests as a single rental real estate activity.

Qualifying as a real estate professional allows you to overcome the presumption that all rental activities are passive. This means that for tax purposes, real estate professionals can deduct losses in an unlimited amount and avoid the Net Investment Income Tax. It is important to note the real estate professional status does not require that you be a licensed real estate agent.

Respect the tax rules related to rental real estate and report your activities accurately.

There is another requirement that must be met in supporting the “real estate professional” status. It is imperative that documented contemporaneous records be kept, and these records must be bulletproof to substantiate one’s real estate professional status claim. These records must clearly show the time spent and the services performed for these activities.  Without records, if you are audited, the IRS will disallow passive activity losses, from a tax perspective.

As a freelance business owner, the income from real estate income can be attractive, and losses that reduce your taxable income may be one of the most attractive perks associated with real estate investing. In addition, when it comes to being a real estate professional, investors can use losses and depreciation to their advantage.  Remember contemporaneous records are required to substantiate hours and active participation and as always, consult with a qualified tax professional if you have questions regarding real estate and rental property transactions.