Simple Tax Election can Save you Thousands on your Real Estate

planUnderstanding the rules before playing the game is important, it is something that we are taught from an early age.  When opening up the box of your first board game, and then proceeding to scatter all the pieces across the table, you realize, that nothing will make sense until you read the rules.  In Monopoly, where most of us took our first crack at real estate, we would not understand how to purchase property, pay rent when landing on someone else’s property, or even that we got to collect $200 when we passed go, if we did not first read the rules.

In real estate, and life in general, the same standards apply.  Reading the rules and following instructions are key to playing the game.  It keeps us knowledgeable and helps us to avoid making costly mistakes.

When it comes to dealing with the IRS it is best to be prudent.  Failing to correctly read directions and follow the instructions outlined in the tax code can cost you thousands.  If you want to get your tax break, it is best to fill out and file all of the necessary forms in the manner the IRS instructs.

Anjum Sheikh, an owner of four rental properties, learned his lesson with the IRS the hard way. 

During the years of 2003 and 2004, Sheikh experienced losses on one his properties of $10,006 in 2003 and $9,511 in 2004.  It is to his advantage to deduct these losses on his income tax return as the IRS has a $25,000 rental real estate allowance under IRC § 469(i)(8) that allows individuals to offset losses from rental real estate.  However, in order for this loss to be deductible, it was necessary that Sheikh "actively and materially" participated in the management of the property.
The IRS defines material participation as satisfying any of the following tests:

  1. You participated in the activity for more than 500 hours.
  2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
  3. 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 did not own any interest in the activity) for the year.
  4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities, under Recharacterization of Passive Income, later.
  5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
  6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

  You did not materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity does not count in determining whether you materially participated under this test if:

  • Any person other than you received compensation for managing the activity, or
  • Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).

To satisfy the qualifications set by the IRS for material participation, Sheikh combined all of rental properties (activities) into one "activity".  This way, he could count the hours he spent "actively and materially" participating on the rental properties collectively instead of individually for each property.

You may be asking yourself, what is the catch?  Or, Why is Sheikh’s situation important?

Well, things were looking great for Sheikh, except, he did not follow instructions.  This same rule of always following directions, reading documents before you sign them, and in general being informed, applies to many situations.  In Sheikh’s case, we learn our lesson monetarily.

Failure to follow directions can be costly.  The act of combing rental properties to make one "activity" is referred to as aggregate election.  An election statement must be filed with an original income tax return for the tax year in which it is made. 
The problem is, Sheikh never filed his election statement.  He argued that because he consolidated his rental activities on Schedule E and the Supplemental Income & Loss, that his interests in rental properties should be considered as a single real estate activity for the purpose  of the material participation test.

In Tax Court, the IRS claimed that the rental properties should be treated as individual activities because no formal election statement was filed.  Since he did not file the election statement, the IRS also found that he did not "actively and materially" participate in managing all of the properties.  The Tax Court sided with the IRS and evaluated the properties separately.  Consequently, the losses produced by one of the properties were not deductible.

This situation could have been easily avoided by Sheikh if he had simply sent in his election statement with an original income tax return.  However, he decided to attempt to use a shortcut and he lost the game big time.

Posted by Clint Coons, asset protection attorney, Seattle, WA

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