If it feels like the rules for accurately filing your taxes seem to keep changing, you’re not alone or going crazy, because they are. IRS rules get implemented through the legislative process, and they can, in fact, become modified, clarified, or expanded even after tax laws have taken effect. It’s a curious moving target to have for a major legal requirement. Consequently, we hire tax accountants, attorneys, and others with professional specializations to navigate the rules and help make sense out of the confusing task that is documentation, filing your taxes, and maintaining those records.
Everyone wants to pay the least amount in taxes as possible. We have many options to choose from that can lower our tax bills and maximize the benefit of business income losses. However, we need to be careful about how we apply the tests, which allow us to record those losses. Passing through multiple checks is especially true with passive activity loss rules. This post will guide you through some of the requirements and some questions to ask your financial advisor about how your level of participation in business activities apply in these situations.
Passive activity loss rules: the real estate example
Let’s use real estate as a guide to demonstrate what is and isn’t a passive income business, and hypothesize a scenario in which you own a real estate business. Say you own commercial real estate, but your main source of income is representing clients as a real estate broker. You also own commercial real estate through a partnership but do not manage it. The manager of the LP mails your quarterly statements, and you receive other electronic communications about your equity ownership and the income you earned the prior quarter. The manager reports a loss. Since your real estate investment income is entirely passive, it means that you don’t pass the material participant test. However, as a commercial real estate broker, you are a material participant since you spend at least 500 hours a year conducting the business. IRS rules don’t allow you to migrate the losses from your LP ownership to your brokerage business.
The good news is you can carry forward any realized losses into more profitable future periods virtually without limitation. However, just because you begin to record passive income losses, doesn’t mean you can backdate present-day losses for prior periods. The same rules apply if you were to lose money as a real estate broker but had an unusually good year in your property investments. Income losses from your brokerage business will not lower the taxable income on your commercial property investments.
The same is true for private market general partners. In a scenario where you manage real estate investments with other managers who aren’t compensated, the work you contribute to the business is still considered passive activity by the IRS. The legal entity, whether an LP, LLC or other designation is not the focus for material participation tests.
Form 8582 & the material participant test
Form 8582 has a section that has a special allowance for recording passive activity losses if you gain income on rental real estate activities as an active participant. It contains a series of seven worksheets that you must complete before entering values on the form. The worksheets identify other exceptions to passive activity loss rules, such as commercial revitalization project deductions. Rules also stipulate that losses from passive activities can’t exceed income from passive activities.
The IRS defines material participant based on a series of 7 tests. You only need to pass one of them. They include:
- You participated in the activity for more than 500 hours.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
Trying to figure out on your own whether the business activity you engage in should be categorized as “passive activity,” “active participant,” or “material participant” is frankly a daunting task. This post only scratches the surface of how losses and income from business activities need to be documented, recorded, and reported on Form 8592 and other tax forms. The IRS has many caveats to the filing instructions, and seeking the advice of a qualified and experienced tax expert will be your best bet in ensuring that you are doing everything by the books.
Finding the best tax expert for you
SD Mayer Private Client Services helps investors to navigate IRS tax rules by identifying opportunities to reduce taxable income by systematically applying those rules. They can help you to accurately carryforward your income losses where they cannot reduce taxable income in the current tax year. You need a tax advisor who can review your investment portfolio and build a strategy around your current and future investment plans. Does contingency planning come to mind? Talking to a wealth management professional at SD Mayer is the best place to start.
Tax accounting is a evershifting world, but you don’t have to navigate it alone. Our certified accounting team can guide you through these complex processes—for you or your business.