One of the most misunderstood areas of real estate is the real estate professional (REP) designation. The REP designation is an exception of a general rule. The general rule is that all trades or businesses where the owner does not materially participate AND ALL rental real estate is passive.
This is under Regulation 469, which is designed to alleviate tax shelters. Rental real estate can create large tax shelters simply because of accelerated depreciation, which, if not categorized as passive, could offset income from other non-passive sources. For example, a doctor who owns rental property and shows a $50,000 loss on that property simply because of depreciation could reduce his wages from his practice by $50,000. That is a tax shelter, and any activity put in place without economic substance solely to avoid taxes is prohibited.
Rental real estate also generally does not require large amounts of time, especially if a property management company is used, so it was a perfect tax avoidance strategy before 469, which was passed by Congress in 1983. But, because of complaints from real estate owners whose only business was real estate, Congress passed an exception to the general rule.
A REP designation will allow the owner to offset gains from other real trades (assuming material participation) or businesses with losses from rental real estate. The other advantage is the REP does not pay the additional 3.8 percent net investment income tax, which was passed by the Obama Administration on all passive rental real estate.
Also, the depreciation losses can be applied to all the real trades or businesses the owner materially participates in. Real property trades or businesses include:
- Real property development
- Rental, operation, management, leasing, or brokerage
For example, a home builder who owns rental real estate can offset his home builder income with losses from his rental real estate. This is because home building is a real property trade or business.
By: Kevin Jerry, Executive Vice President