This article discusses the three income categories for segregating the income, profit and losses resulting from property ownership, and the rules for determining the tax consequences within each category.
The many types of income
A central concept, requisite to understanding the tax aspects of annually reporting real estate operations and sales, is the existence of three income categories, sometimes referred to as income pots. The category, or pot, into which a property falls controls the accounting and the reporting of the property’s income, profits and losses, collectively called income by the Internal Revenue Service (IRS).
When an owner of real estate, his accountant or broker prepares an estimate of the owner’s annual income tax liability, the owner’s total income, profits and losses from all sources are first classified as belonging in one of three income categories:
· professional trade or owner-operated business opportunities, called trade or business income, including any real estate owned and used in the production of the owner’s trade or business income [Internal Revenue Code §469(c)(6)];
· rentals and non-owner-operated business opportunities, called passive income [IRC §469(c)(1)]; and
· investments, called portfolio income. [Revenue Regulations §1.469-2T(c)(3)]
The categories relate to the type and use of the real estate generating the income, profit or loss. The vesting employed by the individual owner or co-owners to hold title is not relevant, unless a C corporation, taxable trust or estate of a deceased holds title as the owner and operator of the property since they are taxed separately from their owners (shareholders or beneficiaries).
For example, the ownership of rentals (exceeding 30-day average occupancies) by a limited liability company (LLC) is not a trade or business of the LLC or its owners, called members. Each member of the LLC reports the income, profit or loss from the rental operation as passive category income since an LLC is treated as a partnership. Thus, as in any partnership, income is passed through to the members before it is taxed. [IRC §701]
Conversely, property management services rendered by an individual broker on behalf of owners of rentals constitute a trade or business category activity for the broker.
The three income categories are mutually exclusive of one another. Simply put, losses from one category cannot be used — commingled — to directly offset income or profit within another category. Each category is tallied separately to establish the end-of-year income, profit or loss within the category.
If a reportable end-of-year income or profit exists within any category, it is added to the owner’s adjusted gross income (AGI). However, if the end-of-year result is a reportable loss, only the amount of loss in the business category is fully subtracted without qualification from the AGI.
Each category has different internal accounting rules. For instance, the operating income or loss from each assessor-identified parcel of rental (passive) category property owned by the taxpayer is treated and accounted for separately from that of every other parcel of rental property the taxpayer owns (unless in the same complex), called tracking. The tracking is necessary to maintain the integrity of suspended losses as available only for the offset of income or profit on the property which generated the loss. No such tracking requirement exists within the business income category or the portfolio income category.
Another accounting difference unique to the passive income category is the requirement that an annual operating loss on rentals be carried forward, called a suspended loss. Any rental operating loss which becomes suspended is only deductible in future years from income or profit reported on the properties that generated the loss.
Further, the rental operating loss cannot be used to offset income or profit in other categories, unless the owner qualifies for either:
· a real estate related business adjustment to his AGI; or
· the $25,000 rental loss deduction from his AGI.
In contrast, portfolio investments, such as land and management-free, triple-net and long-term leases, while not subject to the tracking of losses by parcel, gather together the annual income, profits and losses from all properties within the category. If an annual operating loss is incurred within the category, the loss is carried forward to offset income or profits in future years from any source within the portfolio category.
As for offsetting between the categories, the end-of-year income, profits and allowable losses are first totalled within each category. The totals from each of the categories are then brought together (subject to limitations on passive or portfolio losses) to establish the owner’s AGI.
For the owner or broker to analyze and estimate the owner’s annual income tax liability resulting from a sale or purchase of real estate, two major accounting components must first be estimated:
· the owner’s AGI, derived from any net annual operating income and sales profits generated within each income category, less any loss from the trade or business category, loss on the sale of rentals, rental operating losses allowed for owners involved in real estate related businesses, and capital losses up to $3,000 from the portfolio category; and
· the owner’s taxable income, the AGI less personal deductions, exemptions and any $25,000 rental property operating loss deduction.
Business category or owner’s trade
Trade or business income and loss includes:
· earnings from the individual’s trade or business and use of his real estate in the conduct of that trade or business, including ordinary income from the sale of parcels held as inventory by subdividers, builders and dealers [IRC §469(c)(6)(A)];
· income and losses from the individual’s business opportunity (sole ownership, partnership, LLC or S corporation) and the real estate owned and used in the business, if the individual is a material participant in the management of the business [IRC §469(c)(1)]; and
· income and losses from the individual’s owner-operated hotel, motel or inn operations (sole ownership, partnership, LLC or S corporation) with average occupancies of 30 days or less, if the individual is a material participant in management. [Rev. Regs. §1.469-1T(e)(3)(ii)(B)]
Rentals and passive category
An individual’s real estate income property operations (excluding business category hotels, motels and inns), referred to by the IRS as rental income, are accounted for within the passive income category which includes:
· rents, expenses, interest, depreciation from annual operations and profit and losses from sales, of residential and nonresidential rental real estate that has an average occupancy of more than 30 days; and
· income or losses from business opportunities owned or co-owned but not operated by the individual (no material participation in its management). [IRC §469(c)]
Income received from rental operations is often referred to as passive income. Ironically, for income property to be a rental, and thus reported within the passive income category, the owner must be committed to the active management of the property.
To be considered active in the management of a property, the landlord must have some legal responsibility to care for the property under his lease(s) or rental agreement(s). If the landlord has no responsibility for care and maintenance of the property, such as occurs in a long-term, triple-net lease agreement since the tenant cares for and maintains the property and structures, the income property is a portfolio category property, not a passive category rental property due to the lack of management requirements on the ownership.
An owner who rises to a higher level of activity in rental operations or in a real estate related profession, called a material participant, such as an owner/operator of rentals, a licensee providing real estate brokerage services or a real estate developer, qualifies to write off all rental operating losses for the year against income from all categories to reduce the owner’s AGI, and thus his taxable income. [IRC §469(c)(7)]
Investments held for profit — portfolio category
Investment income, profits and losses taken by an individual, referred to as portfolio income by the IRS, include:
· interest earned on bonds, savings accounts and secured or unsecured notes (such as carryback trust deeds, interest on delayed §1031 reinvestment funds, and trust deed loans);
· annuities, dividends and royalties from personal property investments (stocks, bonds, commodities); and
· income, profits and losses from the ownership of land subject to ground leases, management-free, triple-net leased real estate and unimproved land held for profit on resale. [IRC §469(e)(1)(A)]
