Investing in Real Estate: Tax Considerations from Reagan to Now

In the early 1980s, it was commonplace for small business owners and other high-income professionals to invest in rental real estate properties or, as they were commonly known then, tax shelters.

The most popular versions produced either positive cash flow coupled with tax write-offs in the early years or high tax losses with little to no cash flow. These types of investments are no longer available with the same degree of tax benefits as in the 1980s.

The New Rules of the Real Estate Game

The real estate world was turned on its head by the Tax Reform Act of 1986, and the most important change within that Act was the introduction of the passive activity loss (“PAL”) limitation rules. The PAL rules prevented a taxpayer from deducting any losses from a passive activity (which included rental real estate) unless the taxpayer had passive activity income. An exception was made for real estate professionals who met the following criteria: (1) more than half of their personal service time was spent doing real estate activities in which they materially participated and (2) said real estate-related activities had to exceed 750 hours during the year.

Takeaways for the Amateur Investor

Why should nonprofessional real estate investors (“amateurs”) pay attention to PAL rules? First, even as an amateur, you may be able to qualify for tax benefits similar to what a professional may receive. Second, if you know what the ceiling is on tax benefits, you won’t be tempted to invest in deals that offer tax benefits that are only available to professionals.

The Benefits of Being an Amateur Investor

What does it take for an amateur to be “in the business”? As a reminder, the benefit of being considered a real estate professional is that you will be able to make use of tax losses from a real estate investment even if you don’t have any income from real estate investment sources.

The IRS is stingy when it comes to allowing amateurs to deduct rental real estate losses in excess of rental real estate income. However, a way for an amateur to qualify for “excess real estate loss” is to meet all of the requirements for the active participation special allowance, which are as follows:

  • Actively participate in the real estate activity, which means that he or she must exercise independent judgment over the key activity decisions and not merely ratify decisions of someone else.
  • Have modified adjusted gross income (MAGI) of no more than $100,000 to qualify for the maximum active participation special allowance of $25,000. (MAGI in excess of $100,000 will cause the special allowance to be reduced by 50 percent of every dollar of MAGI in excess of $100,000.)
  • Own at least 10 percent of the investment entity.
  • Avoid being a limited partner in a limited partnership. (Though it is acceptable to be a member of a limited liability company.)
  • Be an individual, a qualifying estate or a qualified revocable trust that made an election to treat the trust as part of the decedent’s estate.

The pre-1986 days of mega tax shelters are gone, for better or for worse, but many tax advantages remain for the modern real estate investor. To eliminate subjection to PAL rules, first consider whether you can qualify as a real estate professional. If you can’t meet that stringent test, which screens out a large percentage of people, don’t let your amateur status deter you. Get qualified for the active participation special allowance and deduct up to $25,000 of loss from the activity of your nonpassive income.