Taxpayers who become commercial real investors are often tasked with filing numerous elections on their initial tax return. Such elections include the election to opt out of the interest expense deduction limitation of Internal Revenue Code (“IRC”) section 163(j). Additionally, if a taxpayer is considered to be a real estate professional (“REP”), she may file an election to treat her passive interests in real estate activities as one activity for material participation purposes, which if satisfied would allow her to bypass any passive loss limitation.
Despite the importance of the above tax elections, along with others available to real estate investors, there is one election in 2020 that may be the most important election — the 2020 Presidential election.
Democratic presidential nominee Joe Biden has offered a number of proposals that would raise taxes on individuals with incomes above $400,000 and $1,000,000, encompassing ordinary income treatment for capital gain, payroll tax increases and others. His plans would raise taxes by more than $4 trillion that can be used to fund his agenda. The information below is a brief summary of how Joe Biden’s proposed tax plans could change the dynamics of the taxation for real estate investors.
Under IRC section 1031, a taxpayer may defer paying tax on capital gain upon the exchange of like-kind property for similar like-kind property under certain circumstances. First, the exchanged properties must both be real property. Additionally, the properties must be used for business or investment purposes. Real property that is improved is considered like-kind property when exchanged for unimproved real property. Property held for sale to customers in the ordinary course of a trade or business (i.e., inventory) does not qualify. Finally, personal property does not qualify under these rules. If cash or other nonqualified property is received in the transaction, it may trigger a full or partial recognition of gain.
In order to raise the $4+ trillion outlined above, Biden is considering the elimination of the like-kind exchange rules.
Real Estate Professional Election
The passive activity loss rules outlined in IRC section 469 prevent passive losses from offsetting non-passive income from a trade or business. In fact, according to section 469, all rental income is per se passive income. There is an election available to REPs that allows the use of passive losses to offset non-passive income. If a taxpayer is eligible to make this election, then any rental real estate losses may be used to offset non-passive income from another trade or business.
A taxpayer can qualify as a REP by meeting the following tests:
First – The taxpayer (or spouse, if joint return) must spend the majority of his or her work time in personal service activities in any real property businesses (“RPBs”). RPBs include the following: development, pre-development, rental, management and construction. For the purpose of this test, the activities do not have to be rental activities (just real estate activities).
Second – The taxpayer must spend 750 hours or more, in total, in all of the real estate activities in which he or she materially participates.
Passing the above tests does not mean the analysis is complete. Once a taxpayer is considered a REP, the rental losses received by the taxpayer are no longer passive per-se. But that does not automatically make them non-passive, or active. In order for such rental losses to be considered non-passive, the taxpayer must “materially participate” in the rental activity. Material participation in activity means involvement in the operations of the activity on a regular, continuous and substantial basis. Although there are seven quantitative tests in establishing “material participation,” participating in the rental activity for more than 500 hours in the tax year (the most frequent test) will be sufficient in most cases. The grouping rules under section 469 allow taxpayers, under certain situations, to group separate rental activities together to reach the 500-hour test.
2020 Election Tax Policy Resources
Although the 2020 election is still a few weeks away, tax planning should be an ongoing process and maintaining an awareness of the rules and possible changes is crucial. Please reach out to your Withum tax advisor if you have questions about the information discussed in this article.
Author: Jeffrey A. Clayman, CPA, JD, LLM | [email protected]
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