Non-Working Spouse and a Rental Property Create a Tax Planning Opportunity
One issue that comes up quite frequently with our clients is one spouse working and generating more than $200k annually, one spouse serving as the homemaking household manager, and a passive investment rental property generating rental income. The losses build-up continually because no one has provided the clients an alternative solution. They assume that since they earn too much, they’re subject to the Passive Activity Loss Limitation (PALL) rules with no planning opportunities. Nothing could be further from the truth.
Treas. Reg. § 1.469-9(c)(4) explains that only one spouse needs to qualify as a "real estate professional" to fully deduct rental losses. Most people assume that a “real estate professional” means you have to be a licensed realtor. That's also incorrect. In the practice of law, it's all about definitions.
Treasury regulations define a “real estate professional” as any person that independently passes both the “more than one-half of personal services” test and the “greater than 750 hours” test.
Anyone that has full-time employment cannot reasonably claim to pass the “more than one-half of personal services” test since full-time employment presumes annual work hours of 2,080, which means you would need to prove that you spent at least 2,081 hours managing the rental property. Absent managing a very large rental investment real estate portfolio, you’re unlikely to overcome this hurdle, especially since a Form W-2 always let's the IRS know you have 2,080 hours spent elsewhere. A W-2 and a claim of active management of a rental guarantees an IRS audit.
On the other hand, for a non-working spouse, this is easily satisfied since there are no employment hours to compare against. A single hour managing the rental property would suffice. However, the ”greater the 750 hours” test would be the harder test to satisfy. Surprisingly, it's actually not that difficult to satisfy.
The ”greater the 750 hours” test requires that you perform at least 750 hours annually managing the rental property. That’s less than 2.1 hours per day. This is where we assist clients with maintaining a spreadsheet to track their duties and tasks each day. Time logs and records memorializing the day, time, and specific activities that were performed.
By satisfying both the “more than one-half of personal services” and “greater than 750 hours” tests, the non-working spouse would be deemed to be a “real estate professional,” which means all losses generated by the investment real estate rental property are now fully deductible without limitation.