Donald Trump is soon to become a very busy man. Building a wall, renegotiating trade deals, and trying the cast of Hamilton for treason all require significant man-hours. As a result, if he intends to make America great again, he’ll have to hand over the keys to his real estate empire to a temporary replacement. And unfortunately for the President-elect, this re-directed focus will cost him millions in tax dollars.
Let me explain.
The three pages of Trump’s 1995 tax return that were published by the NY Times indicate that Trump claimed a $916 million net operating loss as well as a $15 million loss from his various rental properties. And while the nearly $1 billion net operating loss deservedly garnered all of the attention, the reality is it was likely an anomaly in his tax history – a one-time tax blip that was a function of a perfect storm of forgiven debt and outdated tax law.
(Photo by Joe Raedle/Getty Images)
The rental loss, however, reflects a more recurring, continuous part of the Trump tax picture. Of course, we’ll never know that for certain, because Trump broke 40 years of tradition by refusing to release his returns throughout his campaign, and now that he’s won the White House, likely sees no need to relent and do so.
Nonetheless, now that Trump will be busy with the Presidency, there is one thing we can know for certain: the tax benefits from his rental losses will disappear.
You see, your average Joe Six-Pack can’t deduct net losses from a rental property. This is because rental activities are considered “passive activities,” and under the tax law, you can only deduct losses from a passive activity to the extent you have income from a passive activity. Why is this the case?
To understand the answer, you have to travel back in time to 1985, before the concept of passive activities existed. Back in ’85, if you were a doctor making, say, $200,000 a year, you could significantly reduce your tax bill by taking your extra cash and buying a rental property.
Rental properties – even the profitable ones – tend to generate a tax loss due to substantial depreciation deductions taken against the purchase price of the home. Thus, the doctor would claim a large rental loss, and use that loss to partially offset the income from his day job of treating patients. It was win-win-win: the doctor 1) pays less tax, 2) due to a loss generated largely through non-cash deductions, and 3) while the house may be depreciated for tax purposes, in reality, the home is appreciating in value all the while.
This result didn’t make Congress too happy; over time, rental properties became viewed as all-too available tax shelters. To curb these perceived abuses, as part of the Tax Reform Act of 1986, Section 469 of the Code was enacted. This provision drastically changed the rules, because it set the standard that all rental activities default to being passive activities, and as stated above, losses from a passive activity may only offset income from a passive activity.
Put it all together, and after 1986, the doctor’s tax shelter went up in smoke: the rental loss – as a passive loss – could no longer offset the income from treating patients, because that income – as earned income from the doctor’s day job – is nonpassive income. Instead, the rental loss would get suspended and carried forward, waiting for the day the doctor either generated some passive income or sold the rental property, at which points in time the loss would be allowable.
Soon after the enactment of Section 469, however, a part of the population collectively screamed “UNFAIR!!!!” Who were these people?
Consider the following example: a developer is in the business of building homes. He has two separate projects: in the first, he builds Neighborhood 1, in which he constructs 80 homes and sells them all off to customers, generating substantial income. In the second, he builds Neighborhood 2, in which he constructs 80 homes and rents them to tenants, generating a substantial rental loss.
The developer is clearly in one business, but after the advent of Section 469, he is engaged in two separate activities: a sales activity and a rental activity. And under Section 469, the rental activity is passive, regardless of how hard the developer works in constructing and renting those 80 homes. As a result, the developer gets whipsawed – he can’t use the passive loss from the rental activity of Neighborhood 2 to offset the nonpassive income from the sales activity of Neighborhood 1.
This is patently unfair. The developer is clearly engaged in the “real estate business,” developing, constructing, selling, and yes, renting property. But because one part of his overall business is a rental activity, he cannot use that loss to offset the income from the other aspects of his business. In summary, a provision that was created to prevent a doctor from sheltering his income with a side-rental property was now denying a rental loss to someone who truly worked, day-in and day-out, in the real estate world.
To remedy this injustice, in 1993, Congress enacted Section 469(c)(7), the so-called and unanimously misunderstood “real estate professional rules.”
These rules are designed to help the developer in our example use rental losses without limitation, while continuing to prevent the doctor from our initial example from deducting rental losses against his doctor income. It does so by providing that a taxpayer who qualifies as a “real estate professional” will not have his rental activities automatically treated as passive, and may instead show that the rentals are in fact nonpassive by establishing that he puts enough hours into the activity. Once the rental activities become nonpassive, the losses from the activity can be used without limitation to offset other sources of income.
To qualify as a real estate professional, you must meet a couple of tests. First, you must establish that you work in a “real property trade or business,” things like property rental, management, development, construction, or brokerage.
Next, you must add up the hours you spend in that real property trade or business, and those hours must satisfy two separate tests. First, the hours must exceed 750. Second, the hours you spent in your real property trade or business must represent more than half of the hours you spent in all of your businesses during the year. Pass those two tests, and you are a real estate professional, meaning your rental activities are not automatically passive. As a result, if you can show you worked enough hours in your rental activities — generally 500 hours in all of the rental properties combined will get you there — the losses from those rentals will be fully deductible against all other income.
It is likely that few people have benefited more from the advent of the real estate professional rules than Donald Trump. As a real estate mogul with countless high-end rental properties scattered across the globe, the addition of Section 469(c)(7) to the Code offered Trump a tremendous benefit that would otherwise been available — the ability to deduct rental losses without limitation.
And there’s nothing wrong with that. The real estate professional exception was designed for people like Trump, and quite frankly, if he shouldn’t benefit from them, no one should. He clearly worked in all aspects of the real estate world, and it would be incredibly unfair to treat his rental losses as the same type of tax shelter than benefitted the doctor in our initial example.
But Trump’s tax break is about to come to an end, and the reason is obvious: as the 45th President of the United States, Trump is going to have a new day job; specifically, one that is not in a “real property trade or business.” As a result, the hours Trump spends meeting with the Cleveland Cavaliers or giving an inspirational speech to a rag-tag collection of pilots hoping to take down an alien mothership will not count towards satisfying the two real estate professional tests. To the contrary, those hours will instead go into the denominator of the “more than half” test, making it impossible for Trump to show that he spent greater than 50% of his time on his real estate work in 2016 and beyond.
As a consequence of failing to qualify as a real estate professional, Trump’s rental losses will become passive, and will not be permitted to reduce his other sources of income.
In the past, we’ve seen countless accountants, lawyers, teachers, and even IRS agents show up in Tax Court, attempting to argue that they have spent more hours on their real estate work than they did their day job. They have all failed, because obviously, when the Service can establish that you spent 1,800 – 2,000 hours at your day job, you’re going to be hard-pressed to show that you spent more time on your real estate work.
Of course, we’ve never had a sitting President argue that he satisfies the “more than half test” and qualifies as a real estate professional, but this is Donald Trump we’re talking about. Trump never goes down without a fight, so he just might be the first.
(if you want to understand more about the real estate professional rules, give this a read. Or, you can sign up for a this handy little 2-hour webinar I’m teaching this Tuesday, November 22nd, at 1PM EST.
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