Income Tax Consideration: Passive vs. Non Passive Income and Loss

Dear Fellow REIClub Members,

I’ve just in the last year and a half changed my Job Career to Real Estate. I’ve spent most of it learning about investing and going to numerous Seminars and Boot Camps. I’ve decided to concentrate my efforts in purchasing Commercial Properties although I’ve just recently purchased a great cash flowing single family home already with a tenant included. I also created an LLC (as Member/Manager) just last year and now I’m concerned as to how best to file my Income Tax for 2007. Prior to that, I’ve always filed jointly and for the Tax year of 2006, I claimed my new Career as Real Estate Investor.

My question is, should I now look at claiming myself as a Real Estate Professional? How will it effect my passive vs. non-passive Income and Loss on rental property? Buy the way, I do qualify as meeting the Tests for a Real Estate Professional. :help

only thing it does is remove the $25,000 passive loss limitation (real estate professionals can offset passive losses in excess of $25,000 against other income)

other than that, it makes no difference on taxes paid personally. doesn’t apply to the LLC unless it is a disregarded single member entity.

incidentally, real estate professionals also remove the AGI cap to claim passive losses at all.

Other than owning a rental property, what does your real estate business do that you are a real estate professional?

Thanks Dave for your reply.

I Qualify as a Real Estate Professional by meeting the following Tests:

  1. I spend over 8 hours per day at least 6 days per week following potential leads on Properties for sale - both residential and commercial. I get these listings either from Loopnet or thru private offerings, that I get emailed to me daily. I’m also an Equity Partner that has a invested percentage on a 185 unit apartment complex, I spend at least 10 hours a week reviewing and studying real estate books, making at least one offer per month on property to which I’ve personally inspected with either my Residential Real Estate Broker and my Commercial Real Estate Broker. I have a standing relationship with Bank of America Financial Brokers and Loan officers, I also have an Attorney (who just did my closing for me last year) that also is a real estate investor. The closing that I just completed was on a single family home which I own 100% and have approximately 2% ownership in the apartment complex mentioned above (Equity Partner only - no voting rights). I’m also the sole partner in my LLC as a Member/Manager. I do the renting and screening of my Tenants, hiring of contractors for my property and the paying for those repairs that I deam required for the upkeep of the property. I do all this on a more than full time basis. Where possible, I do some of the maintenance myself - mostly preventive type. I’ve put in over a hundred hours in training for investing in real estate last year.

Therefore, I meet both the percentage of time, hours and material activity to qualify as a Real Estate Professional - although I’ve just been doing this a little over a year and a half. Before that, I was a Technical Consultant working for IBM with two degrees in Electrical Engineering for 7 years and most of my Engineering career was in Telecommunication. AT&T before the split, and ITT before the sell-off.

Now I need some advice as to what’s best for reporting Income and Loss under either a Passive or Non Passive claim and also, do I need to change my Internal Revenue Code? Remember, real estate investing is now my new career, how do I list it with the IRS?

At this time, I’m trying to do my own accounting since the CPA that I hired last year (at a very expensive cost) didn’t work out.

Dear McWagner,

I see that you are a CPA which is great.

There’s two things that you stated that I’m not clear on:

1.“doesn’t apply to the LLC unless it is a disregarded single member entity.” Disregarded single member entity. Does that apply to my situation? I’m a single partner (Member/Manager) of my LLC? Please explain.

2.How does removing Adjusted Gross Income Cap allow for using passive loss and why would they us it.

Finally, the question that I asked Dave, since I see and feel that I qualify as a Real Estate Professional, how should I code it with the IRS on my 1040?

Thanks in advance for your input and response concerning this matter.



ah…but do you have a W-2 job that takes over 20 hours per week?

Having a W-2 that looks like a “job” to the IRS will create questions regarding the real estate professional qualification.

Again, the real estate professional designation does nothing except remove the passive loss limitation. it can be claimed from year to year depending on facts and circumstances. your first year you need to attach a statement to your return advising IRS of your election to be treated as a real estate professional.

You should also be aware that the material participation test applies to each activity of real property trade. ie: you have to meet the 500 hour test for each of your rental properties individually.

You can choose to group all of your rental activities for purposes of meeting the participation test, but then you lose the ability to claim capital gains/losses when individual properties are sold until the last of the group is sold. Then you get into tracking suspended losses for the partial dispositions. Then you have to decide how you will treat new properties purchased, since a new participation test will apply unless you group the new property with the existing properties, thereby further postponing your suspended losses.

So, you can see that this topic quickly gets beyond what can be covered by this message board. You need to find and hire a good CPA who is well versed in real estate and real estate professional issues. Electing to be a real estate professional should only be done as part of an overall investment tax strategy.

  1. depends on how you chose to tax the LLC.

  2. between 100k and 150k of AGI the ability to use passive losses to offset other income is phased out. being a REP removes this cap.

for example: if your wife makes $300k a year while you manage the rental properties that have a tax loss, you are ineligible to take the loss until the property is sold. However, if you elect REP, then you would be able to use the loss yearly to offset wife’s income.

oh, and you should begin keeping a detailed time log, if not already.

Oh, don’t you just love our nice simple tax code… :banghead


To achieve Real Estate Professional status, you must be engaged in an active income real estate business.

From your description, it would seem that you are a limited partner in one real estate venture and you manage your own rental property.

Because you are a limited partner, your partnership interest is a passive income activity. Managing your own rental property is also a passive income activity and does not qualify for real estate professional status.

All the time you spend researching your market for property to buy for your own real estate investment portfolio may be time well spent but it does not make your real estate activity an ACTIVE income business.

In my opinion, your real estate activity does not meet the standard to qualify for real estate professional status, but that is just my opinion. I think you need to resolve most of your tax treatment questions with your own CPA.

In response to both McWagner and Dave T., I have received 1099’s and K1 income statements, plus rental income without receiving or working for an employer that would require generating a W2 for 2007. As I mentioned, I have elected to go into business for myself and have established business permits and established a home office for doing my Real Estate Investing. I am currently working on completing my Business Plan that will allow for Private Investors to participate with me in the purchasing of Commercial properties.

Thanks for the input and I will take another look at considering myself as Real Estate Professional at this time. You both have allowed me to re-consider how I should determine using loss allowance for passive vs. nonpassive losses of up to $25,000.

I actively participate in the management role in a real estate venture, the activity in the pursuit of and offering to purchase other rental properties as a resistered business owner under an LLC, plus the on-going education in the profession of Real Estate Investing. Since most of the initial envolvement for the first 10 out 18 months, has been in the business setup of Real Estate Investing, the study and training phase prior to my actual investing and purchasing my first property may not be seen as meeting all of the IRS Tests ( 1 thru 7) for Material Participation as seen thru the IRS. As far as hours are concern, I feel that I meet more than the minimum hour requirements but may not meet what the IRS consider as a true business participation activity.

I will seek out one of our local CPA members in our TREIA CLUB to help better refine my options and to see what status I should declare on my Income Tax.



I must not have been clear.

To be a real estate professional, you must be engaged in an ACTIVE income activity and meet the material participation tests for that activity as well as the 50% and 750 hour rules.

Your interest in a limited partership generates passive income, so that does not count. The income you derive from your rental property is passive income regardless of your level of active participation. Active participation in a passive income activity does not make you a real estate professional.

All the effort you are spending researching your market to identify suitable rental property to add to your real estate portfolio is still active participation in a PASSIVE income activity. No real estate professional status here in my opinion.

Look at it this way. If a real estate activity done in your own name generates self-employment income, then you are engaged in an ACTIVE income business. Passive income is not self-employment income.

hey Dave,

We’re not talking self employment income here. To be eligible to claim REP you must:

  1. exceed 750 hours of material participation and
  2. exceed 50% of your personal services (ie: must be at least half time) in real property trades or businesses.

real property trades are defined as: any real property development, construction, conversion, rental, leasing, operation, management or brokerage. so managing a personal portfolio of rentals does qualify.

electing REP does not “make” the rental income active, nor impose self employment taxes on such. the income is still passive, but the passive loss limits are removed.

also, each interest in a rental real estate activity is treated as a single activity. thus, to meet the 750 hour rule most investors would have to combine activities, which leads to certain complications that I briefly touched on earlier.

OK, Mark. I will concede that a rental real estate activity in which you materially participae in the operation and management of your own investment properties can qualify for real estate professional status.

I can’t seem to reconcile this comment with IRC § 469(c)(7) which says that income and losses from rental real estate is generally passive except rentals in which a real estate professional materially participates.

If the REP’s rental income is not passive, then what is it? The code does not say specifically, but by inference doesn’t it become active and therefore subject to SE income taxes?

Also, from IRS Pub 925: Disposition of property interests. Gain on the disposition of an interest in property generally is passive activity income if, at the time of the disposition, the property was used in an activity that was a passive activity in the year of disposition. The gain generally is not passive activity income if, at the time of disposition, the property was used in an activity that was not a passive activity in the year of disposition.

What does this say about the profit from the REP’s rental property sale? If the rental income (loss) has been treated as non-passive, then how is the sale profit treated?

I’m stumped.

ok. I’ve mixed terms. rental income for a REP is “active” by definition but “is not subject to SE”. my bad.

The code does not say specifically, but by inference doesn't it become active and therefore subject to SE income taxes?

Nope. because it reports up through schedule E, which doesn’t flow through to the SE. gain on sale is capital (when the final property in the combined group is sold).