Construction business owners are provided an easier path to deducting rental loses by utilizing the real estate professional election
November 25, 2020
Taxpayers with rental activities have incentive to qualify as a real estate professional: if qualifications are met, rental losses that would typically be trapped can be used to offset other business income. However, strict rules exist to qualify and achieving this designation has proved difficult for many. Fortunately, taxpayers in the construction trade may be able to use their real property construction hours to meet the minimum hour requirement. HK partner and construction practice team member, Stephanie Mettille, provides an overview on what this method offers and the elements needed to qualify.
Rental losses and passive income
Recent law changes allow property owners to accelerate a significant amount of depreciation for building repairs, as well as furniture and fixture costs. This depreciation often results in rental activities generating losses for tax purposes. However, real estate rental losses are, by nature, passive, and under the tax law, passive losses can only be used to offset passive income. Passive activities do not include the business you operate on a daily basis, but instead flow through income from businesses one does not spend a significant amount of time in. Therefore, real estate losses generally cannot be used to reduce tax on your primary business income but would instead carry forward until you either have passive income or sell the rental property. Many taxpayers have a hard time deducting these losses, however, business owners in the construction industry have an easier path to qualify as a real estate professional.
Real estate professional election and its two requirements
Election provides an opportunity to group all your real estate rental activities together as one activity and be treated as non-passive. To qualify as a real estate professional, you must meet two requirements:
- Must spend at least 750 hours in real property trades or businesses, and
- spend more than 50% of your time in real property trades or businesses.
One might look at these requirements and assume real property trade or business only includes time spent in the rental space, but that’s not the case. Real property trade or business is defined as real property development, redevelopment, construction, reconstruction, acquisition, rental and management. That means a general contractor can use hours spent managing new construction jobs and hours spent in the rental activity to help meet the 750 hour requirement. This is also applicable to electrical and plumbing contractors and any other construction contractors as long as the time is spent in new construction or reconstruction rather than repair work. With these day-to-day business hours being counted, many contractors may often meet the hour requirement.
Material participation for your rental activities
Once the 750 hour requirement is met to qualify as a real estate professional, you must meet the “material participation” test for those rental activities. Though there are several methods to meet material participation, owners generally look to one of two options:
- Either log 500 hours for the calendar year in rental activities, or
- log only 100 hours if no other employee spends more time than you in the activity within that year.
Activities may include negotiating leases, managing maintenance or other contracts and looking for prospective tenants. If both the professional and material participation hours are met, you’ve successfully reclassified all your rental activities to non-passive, allowing you to deduct any losses against your primary construction business.
Unique opportunity for construction business owners
With the right set of facts and proper planning, construction business owners can save a substantial amount of money in taxes by claiming real estate professional election. Utilizing cost segregation studies on large real estate projects allow for a significant amount of depreciation to be claimed in the first year the building is placed in service. These losses, which might otherwise be trapped, can now be used to reduce the business owner’s overall tax burden and avoid dreaded loss carryovers.
This unique opportunity should be on the radar of all construction business owners who also own rental properties and be explored at least once to discover potential beneficial outcomes.
For more information on qualifying as a real estate professional, or any other questions relating to the tax and construction industries, contact your HK account manager or Steve Campana, construction practice team leader at 888-556-0123 or firstname.lastname@example.org.