By: Lance Williams, CPA, Senior Manager, and Kimber Sutton, CPA, Senior Accountant at Blue & Co.

Its March 1 and you are gathering your tax documents to drop off to your CPA. You have your W-2, 1099s, and financials for your rental property from the management company. You are expecting a decent refund since you had to repaint the exterior and interior of the rental property, which set you back about $20,000.

When you received your tax return, you noticed your refund was much smaller than anticipated. Your CPA explained it’s because you didn’t get to deduct the entire painting expense due to a particular piece of tax law, Internal Revenue Code (IRC) Section 469. This code section refers to passive activity loss limitations, which can cause some unfavorable tax outcomes for many real estate investors. Understanding these limitations may help you maximize deductions and prevent surprises come tax time.

What Are Passive Activities?

Passive activities, generally speaking, are activities you are involved in that are not your everyday job. If you are employed full-time as a chef, which is your only job, and become a five percent limited owner in a dog grooming business, you are likely a passive investor in the dog grooming business. For tax purposes, the chef would not be able to reduce W-2 income with losses from the dog grooming business.

Now let’s assume you work a few hours a week as a line cook, aspiring to own a restaurant one day, and 40 hours a week as the owner and sole employee of a dog grooming business. Your investment in the dog grooming business is likely no longer passive and you would be able to offset losses from it with your wages.

IRC Section 469(c) defines passive activities as any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate. Whether an individual materially participates in an activity is generally determined by seven tests, which requires tracking hours spent and the amount of involvement in that business. You can see all seven material participation tests here.

IRC Section 469(c)(2) give us an exception to the material participation standard, stating that the term “passive activity” includes any rental activity, regardless of whether the taxpayer materially participates. Thus, rental real estate activities are commonly referred to as “per se” passive activities. However, the Internal Revenue Service (IRS) typically has an exception to any rule. If you can establish that you are a “rental real estate professional”, the activity is to be considered a nonpassive activity. Nonpassive activities have fewer limitations on the deductibility of losses and credits, which tends to be beneficial for most taxpayers. For further guidance on qualifying as a real estate professional, please read our article “Do your rental activities qualify you as a real estate professional for tax purposes?”.

Why Is Understanding Passive Activities Important?

The characterization of income as passive or nonpassive affects the timing of when you can deduct losses or claim credits from an activity. With only a few exceptions, passive losses can only be used to offset passive income, meaning they cannot reduce wages, investments, or nonpassive business income. If you have passive losses in excess of passive income, the losses cannot be utilized in the current year and are suspended (carried forward) to future years when there is passive income.

For those individuals participating in real estate activities, there are certain additional exceptions that can be met so that your real estate activities are no longer considered passive. To maximize deductions from your real estate and help prevent suspended passive activity losses, please reach out to your Blue & Co. advisor today to discuss these tax planning strategies.