Year: 2022

Real estate by default is treated as a passive activity for income tax purposes. This means that passive income is included in Adjusted Gross Income, however, passive losses can only be offset by other passive income. In many cases, real estate investing can produce tax losses, and while taxed as a passive activity, the use of these losses is limited.

There may be creative methods to enjoy passive losses. The two which immediately come to mind are if you already have another passive stream against which to deduct passive losses or creating your own passive income stream. Such creativity will be quite involved, so this is not the focus of today’s topic.

Tax losses from real estate can only be fully enjoyed on your tax return if the activity is non-passive. For purposes of our discussion, tax losses may not reflect your actual profit in the activity. We hope that your real estate ventures are profitable, and at the same time, we recognize that there are significant tax benefits to investing in real estate.

How can real estate income and losses be treated as a non-passive activity? For this discussion, non-passive is another term for active activity or material participation. For the most part, changing the nature of real estate from passive to non-passive is objectively measured.

The primary benchmark for material participation is 500 hours annually. There are some exceptions to the 500 hour test. The most notable exception is that you only have to log 100 hours annually if you also have documented time logs for everyone else (non-owners) who rendered services to your investment properties, and – this is important – their time cannot exceed yours. In other words, the activity cannot consume more than 200 hours per year, which is extremely challenging for certain types of real estate, especially short-term rentals.

Unfortunately, real estate activity is still treated as passive income even with material participation. Thus, material participation alone is insufficient.

The status needed to flip real estate activities from passive to non-passive is Real Estate Professional Status. This is claimed on your individual income tax return for property investments taxed on your individual income tax return (Schedule C or E) or through a pass-through entity (i.e., Partnership or S Corporation). Real Estate Professional Status requires logging a minimum of 750 hours annually and at least one-half of all time invested in all income-producing activities.

This means that, by default, a Real Estate Professional cannot be employed full-time and achieve Real Estate Professional status. This is because 750 hours per year are less than your full-time employment. Thus, even if you were able to work 1,500 to 2,000 in full-time employment and log an additional 750 hours in your real estate investments, you would still not qualify because less than half of your time invested in income-producing activities was in your real estate investments.

An example of this is with a married professional, such as physician, attorney or accountant. If the spouse is not employed, the spouse is able to invest 750 hours in the real estate activity. Because this is the spouse’s only income-producing activity, the spouse will qualify as a Real Estate Professional upon logging 750 hours. The spouse could also hold part-time employment, so long as that employment is less than 750 hours.

There are several notable points we should include here as well.

1. Material participation qualifies the taxpayer for the Qualified Business Income Deduction (QBI). This is a favorable deduction against taxable income.
2. Hours invested must be recorded in writing on time logs. This is very important and has been addressed very clearly and affirmatively in the U.S. Tax Court. Similar to mileage logs, time logs must show the date, amount of time, purpose or use of the time, and where the time was spent. The log is not required to be in any specific format, however, the log must not give opportunities for questions. An insufficient time log will undermine a claim to material participation and can give the IRS reason to assess underreporting or accuracy penalties. If your tax return is audited, you should expect that the revenue agent will request your time logs!
3. The property owner’s time must be the largest amount of total time invested if others are also servicing the properties. This includes contractors (or subcontractors) and those engaged for general repair or cleaning. Their time can easily be logged and tracked through invoices showing the amount of time billed.
4. Short-term rentals do not count toward Real Estate Professional Status. This is because short-term rentals are not considered to be a real estate activity. Short-term rental activity may be a business, and this by nature will already be treated as non-passive. If your objective is to flip passive income/losses to non-passive, focus on long-term rentals and real estate investing other than short-term rentals. Short-term rentals include Air BNBs.
5. Even if filing a joint income tax return, the time invested by one spouse permits both spouses to enjoy Real Estate Professional Status.
6. Be cautious of videos and articles on the internet and advice from non-tax professional friends. There are posts, for example, claiming that simply owning a short-term rental qualifies for Real Estate Professional Status. This is incorrect and misleading. You must also prove material participation in conjunction with the activity.

To summarize, real estate income is flipped from passive to non-passive primarily by logging 750 hours annually. Upon successfully achieving Real Estate Professional Status, you will be able to utilize tax losses from real estate investments against other, non-real estate and non-passive income.

If you have questions about time logs, the amount of time required and the time invested by people you may hire, it is best to obtain the advice of a knowledgeable tax professional.

There are many different credentials among tax and financial professionals, and even for a professional office like ours, the variety of credentials can get confusing.

The CPA license is the most common among tax and accounting matters. It is widely recognizable, and the public associates the CPA with income taxes and accounting. However, it is not the only license in the income tax profession.

The CPA is a state license and is administered by a division within the state government. However, a CPA is a comprehensive license which includes income taxation but does not necessarily specialize in taxation. The CPA is primarily a license which regulates accounting services.

The Enrolled Agent (EA) is a federal license granted through the Internal Revenue Service. Instead of considered less than a CPA, the IRS recognizes the EA as equivalent to a tax attorney or CPA. In fact, the EA has the same unlimited practice rights before the IRS as a tax attorney or CPA and enjoys the same attorney-client privilege which is afforded to a tax attorney or CPA.

In short, the EA is a tax specialist who can represent clients from all 50 states in any type of tax matter. This is why the IRS describes the EA as an “elite status.” https://www.irs.gov/tax-professionals/enrolled-agents/enrolled-agent-information

There may be times when a CPA is needed, and this would primarily be for preparing audited financial statements, discovering financial fraud, and forensic accounting. Even then, there is a small number of CPAs who practice in that field. However, for most tax cases, the EA is the equivalent of a CPA or tax attorney.

R. Joseph Ritter, Jr. also holds the CERTIFIED FINANCIAL PLANNER(tm) Professional credential. While we do offer financial planning services as well, the CFP® Professional credential helps us coordinate tax-driven strategies with more comprehensive financial goals. In a three year cycle, Mr. Ritter is required to complete at least 132 hours of continuing education, and most of this is focused on taxation. Our practice is very much focused on taxation, which sets us apart as a tax specialist.

Mr. Ritter’s background includes more than 10 years as a senior paralegal for a Board Certified Tax Attorney, which is experience few tax professionals can claim. This experience in the tax profession has most certainly shaped our practice today.

This is a question I am receiving more frequently, and it seems fitting to address it in a blog post. There are also quite a few articles on this topic, but nearly all of them leave out important points and background information.

The question is usually posed by a business taxpayer treated as an S Corporation, and the client is typically the sole shareholder or owns the company entirely with the spouse. For purposes of this post, shareholder such as for a corporation has the same meaning as the member of an LLC. IRS regulation also applies to shareholders owning more than 2% of the S Corporation.

S Corporation shareholders are required to be paid a “reasonable salary” when providing services to the S Corporation. If you are the sole shareholder and have no employees, then you most likely fit under the requirement of taking a “reasonable salary.” We’re not going to address salary requirements here, but it is an element of the question.

Only employees are eligible for Health Reimbursement Arrangements (HRA). Thus, an S Corporation shareholder who is not receiving wages as an employee will not qualify. In most small businesses, the shareholder is also an employee.

At this point, we should acknowledge that tax regulation on health-related topics for S Corporations is not well defined. The tax professional community has been left hanging since 2015, so the science and technicalities of health care arrangements for an S Corporation are quite complex.

An HRA, more specifically, the Qualified Small Employer HRA (QSEHRA), must be coordinated with an Affordable Care Act compliant health insurance policy. A small employer is one with fewer than 50 full-time equivalent employees. The policy need not be provided by the same employer. For example, the employee may obtain coverage through the Marketplace and participate in a QSEHRA through an employer which does not offer health insurance. (Note: The presence of an HRA will render the employee ineligible for Premium Tax Credits through the Marketplace, and the HRA must be reported on Form 1095-C.)

To this point, it would seem that an S Corporation shareholder who is also an employee would qualify for the QSEHRA. Unfortunately, current IRS regulations do not permit the shareholder/employee and family members from participating in a QSEHRA. However, a QSEHRA can be offered to non-shareholder employees, so long as they are not family members of the shareholder. This rule is unique to S Corporations. Sole proprietors and C Corporations can implement a QSEHRA for anyone who is an employee, even if the employee is the sole proprietor’s spouse or the majority shareholder in the C Corporation.

Here, then, we must differentiate the two types of HRAs. We just discussed the QSEHRA. A different type of HRA is the self-insured plan. First, some brief background.

When the Affordable Care Act was first enacted, the law deemed any type of health reimbursement arrangement, even if it was just to reimburse out of pocket expenses or premiums, as an offer of coverage. Any offer of coverage must comply with ACA requirements, which include minimum essential coverage and coverage for preexisting conditions, among others. Initially, the HRA was all but eliminated under the guise of it being an offer of coverage, or rather, a substitute for health insurance coverage. Because the offer of coverage did not meet ACA requirements, the HRA was essentially deleted.

Although the HRA was brought back in the form of the QSEHRA, an alternative to traditional health insurance is to self insure. Applicable large employers (50+ employees) can adopt a self-insured plan so long as it otherwise meets ACA requirements.

Things get more sticky with small employers. Self-insured plans and HRAs are deemed to be offers of coverage. (The QSEHRA is exempt because it requires the employee be covered under an ACA-compliant insurance policy.) The ACA imposed daily penalties for offers of coverage which did not comply with ACA requirements. Not only does this mean small employers have a number of pitfalls to avoid, the penalties made it cost-prohibitive to offer anything unless the small employer offered a traditional group health insurance plan, which is also cost-prohibitive. Coincidentally, S Corporations were hit the hardest by the ACA.

In 2015, the IRS issued a notice relaxing these penalties for small employers, and particularly for S Corporations, until further guidance was provided, which has not happened yet.

Thus, premium reimbursement arrangements and self-insured plans for shareholder/employees is once again permissible without penalty even if they are not ACA compliant. However, anything offered for the shareholder/employee cannot discriminate against non-shareholder employees. Thus, before you construct an arrangement, you must be sure it is not discriminatory and that your business has the financial capability to include all qualifying employees in the plan.

Still, these arrangements only offer payroll tax benefits for an S Corporation. There is no income tax benefit to the shareholder. The reason for this is that any type of health care coverage or expense reimbursement arrangement is considered a fringe benefit. S Corporation shareholders are treated as partners under partnership taxation rules, and those rules require fringe benefits to be included in wages.

Thus, while the S Corporation can deduct amounts paid under a reimbursement arrangement, the shareholder must include the amount on box 1 of the W-2. There is only an offsetting self-employed health insurance premium deduction available when the S Corporation reimburses premiums for a “qualified health plan.” This terms limits premiums to insurance policies which are state regulated, and the IRS includes Medicare premiums for retirees.

Expense reimbursement arrangements and self-insured plans for shareholder/employees are not premiums because they are not state regulated plans. As medical-related expenses, however, they are excluded from wages for payroll tax (FICA/FUTA) purposes.

Thus, the primary benefit of a self-insured plan for the shareholder/employee will be a reduction in payroll taxes.

It’s been a long post, so we’ll end it here. Contact us if you have questions or would like to discuss these topics for your business.

Cryptocurrency is gaining more widespread acceptance as an alternative form of payment and transfer of assets. The question that invariably arises is how will cryptocurrency be taxed?

The tax landscape is most likely subject to change, however, currently, there are two basic tax impacts of cryptocurrency. First, we should know how the IRS views cryptocurrency. Rather than as liquid cash, the IRS views cryptocurrency as property (illiquid). This view is similar to bonds, stocks, and other types of property held for investment.

Income. Are you receiving cryptocurrency payments in lieu of cash? This mostly applies to businesses but can also apply to individuals receiving cryptocurrency as income. The cash value of the cryptocurrency received is taxed as income. If you hold onto the cryptocurrency received as income, the amount you recognized as taxable income becomes your basis.

Capital Gain. The other tax impact is when holding cryptocurrency as an investment. This will affect most individuals buying cryptocurrency as well as any individuals or businesses which receive cryptocurrency as income and then hold onto it. When you purchase or hold cryptocurrency and then sell it, the gain is taxed as short-term or long-term capital gain, depending on the length of time it is held. This is very similar to other types of property held for investment.

Do know that the IRS is starting to make mandatory answering questions on the tax return as to whether or not you have a cryptocurrency account. Failing to answer this question truthfully can cause problems down the road. Like all other parts of your tax return, you sign it under penalties of perjury.

If you have a cryptocurrency account, be sure to disclose it when contacting our office.