Can real estate professional status free up old passive losses?

Many tax code-defined real estate professionals wonder if they can immediately use prior passive losses once they qualify for real estate professional status.

The short answer is no, and here’s why.

IRC Section 469 background

IRC Section 469 limits the ability to deduct passive losses to offset non-passive income, such as wages, dividends, and interest.

The passive activity rules particularly affect real estate rentals, which are, per se, passive by default.

The income or loss is non-passive if you materially participate in a business. But most rental losses remain passive, irrespective of your involvement, unless you qualify for an exception.

Passive losses follow these three principles:

Passive losses offset only passive income.
Excessive passive losses are disallowed and carried forward to offset passive income in future tax years.
Carried forward passive losses are released in a complete disposition, allowing them to offset both passive and non-passive income.

What is a tax code-defined real estate professional?

The tax code real estate professional exception is Part 1 of a two-part solution that allows you to treat rental losses as non-passive. To qualify as a tax code real estate professional, the following is needed:

Spend more than half of your working time in real property trades or business (the 50% test) and
Perform at least 750 hours of work in actual property trades or businesses during the tax year (750 hours test)

Special rule for employees:

When counting real property work time for the 50 percent and 750 hours tests, the W-2 employee must have more than 5 percent ownership interest in the rental or other real property business. With 5 percent or less ownership, the work time counts as work time but not as rental or other real property trade or business work time.

The IRS defines “eligible real property businesses” as those engaged in

Development or redevelopment
Construction or reconstruction
Acquisition
Conversion
Renting or leasing
Property management or
Brokerage

If these two requirements are fulfilled, you become a tax-code-defined real estate professional. It’s the first step to making your rental activities non-passive.

But to deduct your rental losses against all your income, you must also pass Part 2 of the solution. Part 2 requires that you materially participate in your rental activities. When you meet the two-part solution, you can deduct rental losses against all income.

Former passive activities

What happens to prior passive losses from years before you qualified as a real estate professional?

Unfortunately, those losses remain passive. Real estate professional status only applies to the current year and must be tested annually.

Prior passive losses fall under the “former passive activity” rules in IRC Section 469. You can use the prior losses in three ways:

Offset income from the same activity
Offset passive income from other activities
Deduct the losses upon a complete disposition of the activity

BergerCPAFirst, with over 30+ years of experience, offers comprehensive tax preparation services for individuals and businesses nationwide. Our commitment is to provide personalized attention while ensuring compliance and maximizing tax benefits. If you have any questions or would like to schedule a consultation, please call (201) 587-9200 or send us an inquiry.