Income and losses from any rental activity is generally considered passive. One exception to this rule applies to real estate professionals. Taxpayers involved in real estate rental must overcome two obstacles to avoid the classification of an activity as passive.

First, taxpayers must establish that they qualify as real estate professionals to avoid the general rule that all rental activity is passive.

Second, if the taxpayer qualifies as a real estate professional, the taxpayer must show that they materially participated in the rental real estate activity. If the taxpayer does not meet both of these requirements, any losses from the rental activity will be passive and subject to the passive activity loss limitations.

Real estate professionals may treat otherwise passive rental real estate activities as nonpassive if they materially participate in the rental activity. If a taxpayer is a real estate professional, losses from their real estate activities can be used to offset wages, interest and other nonpassive income.

To qualify as a real estate professional, the taxpayer must meet the following requirements:

• Personal services test. More than 50% of the taxpayer’s personal services in all businesses must be in real property trades or businesses in which the taxpayer or taxpayer’s spouse materially participates.
• The 750-hour test. The taxpayer must spend more than 750 hours a year in real property trades or businesses in which the taxpayer or the taxpayer’s spouse materially participates.
  • Time spent managing a short-term rental property will not qualify for this test. Short-term rental property is property averaging a rental period of seven days or less. This type of property is trade or business property, not real property trade or business property.

Both of these requirements require material participation. A taxpayer materially participates in an activity if they meet one of seven tests.

As previously stated, a taxpayer (individual) is required to pass at least one of the material participation tests to be considered a material participant. If they do not, passive activity rules apply, which means the taxpayer’s participation in the rental real estate activity is not regular, continuous and substantial, and it limits their ability to deduct passive losses on their return.

The test includes:

1. The individual participates in the activity for more than 500 hours during the tax year.
2. The individual’s participation in the activity for the tax year consitutes substantially all the participation in the activity of all individuals (including nonowners) for the year.
3. The individual participates in the activity for more than 100 hours during the tax year and their participation is not less than the participation of anyone else (including non-owners) during the year.
4. The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
5. The individual participated in the activity for any five of the immediately preceeding 10 taxable years (five taxable years do not need to be consecutive).
6. The activity is a personal service activity and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
7. Based on all facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis.

The above is meant to provide general guidance for tax professionals when dealing with clients who may or may not meet the requirements to be a real estate professional. This is a complicated area with many nuances. NATP has a Preparing Taxes for Real Estate Professionals on-demand webinar for those who are interested in learning more.

We’ve also provided a reference diagram of key elements of the material participation tests.

Question: Billy took out a reverse mortgage on his principal residence to provide himself additional income during his retirement years. Billy died and Laura, his beneficiary, paid off the balance of the reverse mortgage so she wouldn’t lose the house. Laura asks you if she can take a deduction on her personal tax return for the Form 1098, Mortgage Interest Statement, issued to the estate when she paid off the reverse mortgage. What do you tell Laura?

Answer: No, the reverse mortgage interest reported on Form 1098 to the estate is not deductible on the beneficiary’s personal return. A reverse mortgage is like a home equity loan. Billy took out a mortgage against the equity of his house and then used the loan proceeds to pay for personal living expenses. Billy did not use the reverse mortgage proceeds to purchase, construct, acquire or improve his principal residence [§163(h)(3)(B)]. Interest tracing deems that the loan is for personal expenses; therefore, the interest reported on Form 1098 is not deductible as qualified residence mortgage interest expense under TCJA, which changed the rules on the type of mortgage interest that qualifies as a deductible expense. Generally, a deduction is not allowed for interest paid on a reverse mortgage; however, an estate is allowed a deduction on the principal and accrued interest it pays on the reverse mortgage of a decedent’s home [§2053(a)(4)].

Data security is a principal concern for tax professionals, who handle and store private financial information to prepare tax returns. Criminals are acutely aware of that fact, and they deploy a dizzying array of phishing scams across traditional and digital media to steal taxpayer data and commit identity theft tax refund fraud.

The persistent threat of data theft is just one reason every tax office needs a data security plan detailing how they intend to protect client information and mitigate data theft events. It’s also required by the Federal Trade Commission Safeguards Rule, which applies to all paid tax return preparers — regardless of office size.

Unfortunately, there isn’t a one-size-fits-all data security plan and knowing where to start can be a significant stumbling block for tax offices. The good news is that breaking down the process into manageable steps can help get the ball rolling:

1. List all staff who handle client data

Begin by designating who will coordinate tax office data security, then create a list of all staff who handle client data. Depending on the size of the office, this might involve identifying each staff member’s responsibilities and the reason they need to interact with client information.

2. Organize office data by type and risk

Create a rubric to help assess the risks posed by different types of information handled by the office. One axis will include information types like client contact information, client personally identifiable information (PII) and employee records, and the other will list risks like lost access, fines, legal fees and damage to reputation. Then assign each information type a score under the risk categories.

3. Inventory devices, software and services that interact with client data

Consider everything in the office that stores, transmits, receives or otherwise handles client data, from smartphones and fax machines to desktop applications and cloud-based services. Then, note the type of data stored or processed by those devices and applications. Keep in mind that tax professionals are also responsible for ensuring all chosen service providers maintain appropriate safeguards.

4. Identify threats and vulnerabilities

List threats to client data and vulnerabilities of office systems, then rank them based on how damaging they could be to the business. Any event that results in losing, changing or destroying client data should be considered, including theft, accidental disclosure, natural disasters and intentional destruction.

5. Address threats and vulnerabilities

Prioritize threats and vulnerabilities, then schedule when each will be addressed; some may require more than one action to resolve. Preventing data theft, for example, might involve installing malware protection, enabling automatic security updates, using multi-factor authentication, and training employees to identify phishing scams and safe web-surfing practices. Just make sure to take care of immediate, high-risk threats first.

Once the tax office security plan is complete, it should be monitored, tested, evaluated and adjusted as circumstances change, from new staff to the latest phishing scams. Remember, if it’s going to help protect client data, it needs to be a living document.

For a free sample data security plan that breaks each of these steps into a separate worksheet, see “Easy Steps to Create Your Mandatory Tax Office Security Plan” on Drake Software’s website.