Typically, losses on rental activities are considered passive activities according to IRS guidelines, meaning losses are only deductible against other passive income (with some exceptions) even if you materially participate in them. However, qualified real estate professionals are an exception to the rule. If you qualify as a real estate pro and materially participate in rental activities you may treat the rentals as non-passive activities and any losses are deductible in full as incurred.
To qualify as a real estate professional you must show that 50% of your working hours and at least 750 hours each tax year are spent in real estate activities in which you materially participate.
One snag – the Tax Court decided that the time spent turning a home into a rental won’t help make you a real estate pro. In this case a software engineer spent over 1,000 hours converting his primary residence into a future rental. The court ruled because his home wasn’t part of his rental business, the hours spent on the renovations aren’t counted towards either test. (Smith, TC Summ. Op. 2014-13).
Stephen Osborne, CPA