For example, if you have passive losses from some rental properties but others throw off passive income, you can deduct losses up to the amount of income. But if you have little or no passive income, your passive losses are suspended (carried over to future tax years) until you either: (1) have some passive income or (2) sell a property with suspended losses, at which time those losses become currently deductible. In other words, your rental real estate losses may be worthless until some point in the indefinite future.

That stinks! The good news is there are two big exceptions to the PAL restrictions. If you qualify, you can currently deduct some or all of your rental real estate losses. So here's the story on how you can legally beat the system and get your rightful tax breaks sooner rather than later.

Plan A: claim the "Small Landlord Exception"

Passing the active participation test is pretty easy. All you have to do is prove that you at least exercise management control over the property in question by, for example, approving tenants and leases, authorizing maintenance and repairs, etc. In other words, you don't have to mow any lawns and unclog any drains to qualify for this break (however, if you do, it won't hurt your case any).

So far, so good. But here's the problem. Many real estate owners are ineligible for the small landlord exception because it's "phased out" between adjusted gross income (AGI) of $100,000 and $150,000.

For example, say you have $24,000 of passive rental real estate losses and your AGI is $130,000 (before considering the passive losses). Under the phase-out rule, your current deduction is limited to only $10,000 (40 percent of the maximum allowance of $25,000).

If your AGI is $150,000 or higher, your completely ineligible. Sorry about that. Now you are back under the general PAL restrictions, meaning you can deduct passive losses only when you have some passive income or sell the loss properties. Once again, that stinks!

Plan B: Claim "Real Estate Professional Exception"

Your tax salvation is courtesy of the so-called real estate professional exception.

It's intended as a break for individuals who make substantial time commitments in real estate.

As you will see, the qualification rules are very tricky (surprise). Don't worry. We will walk you through them. If you find out you're eligible, the tax savings will pay for a lifetime subscription to this newsletter.

Four Steps to Assess Your Plan B Eligibility

1. Evaluate each real estate business in which you are involved to see if you "materially participate" in any of them. Include all your rental properties (treat each as separate business), plus be sure to consider any development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing, or brokerage business in which you are involved.
2. Add up the time spent in each business in which you materially participate to see if you are able to meet tax-law guidelines.
3. If you fail Step 2, "try again" by seeing if making the special election to aggregate all your rental real estate properties (i.e., treat the whole bunch as a single business) would allow you to pass Step 2. If so, consider making the election.
4. Assuming you pass Step 2 (one way or the other), currently deduct all your tax losses from all rental real estate businesses in which you materially participate.

Step 1: Identify Material Participation Businesses

1. You spend over 500 hours annually in the business.
2. You spend over 100 hours in the business, and no one else (including nonowners) spends any more time than you do.
3. You spend substantially all the time that anyone (including nonowners) spends in the business.

For purposes of Step 1, treat each rental real estate property as a separate business.

Example 1: Say you and your spouse together spend over 100 hours taking care of a rental duplex that you own. No one else spends over 100 hours on this property. You pass the 100-hour test and are therefore considered to materially participate in the business of renting the duplex. Say you also own a small apartment building that's run by a management company. You spend only a few hours a year on that property. You fail all three of the tests listed above. Therefore, you do not materially participate in the business of renting the apartment building.

Example 2: You and your wife both work as self-employed real estate brokers. You work full-time (say 1,500 hours per year), while your wife is a part-timer (say 400 hours). Together, you also spend 160 hours (80 hours each) on a rental property (no one else spends more time than you). You are considered to materially participate in both the real estate brokerage business (because you pass the 500-hour test) and in the rental property business (because you pass the 100-hour test).

Step 2: Clear the Time Commitment Hurdles)

• You spend over 50 percent of the time you devote to performing personal services (in other words, working) during the year in real property business in which you materially participate, and
• You spend over 750 hours performing personal services in real property businesses in which you materially participate.

For instance, if you spend 1,800 hours performing personal services of all types, you must spend over 900 hours in real property business to pass the 50 percent test. If you spend only 700 hours performing personal services of all types, there's no way you can qualify because you fail the 750-hour test.

If you are married, either you or your spouse (or both) must be independently pass both tests. In other words, you cannot combine your hours to ass the 50 percent test or the 750-hour test. (As explained earlier, however, you are allowed to combine hours in attempting to pass the material participation tests listed in Step 1).

Example 3: You and your wife file jointly. You both work as self-employed real estate brokers. You work full-time (1,500 hours per year), while your wife works part-time (400 hours). The brokerage activity is profitable. Together, you also spend 160 hours (80 hours each) on a rental property you own (no one else spends more time). The rental property throws off tax losses. For purposes of Step 1, you are considered to materially participate in both the real estate brokerage business (you pass the 500-hour test). So far so good. You also meet the Step 2 time commitment thresholds, because you personally spend over half your time in real property businesses in which you materially (actually 100 percent of your time in this example), and that time is over 750 hours (actually 1,580 hours in this example). Congratulations! You meet the tax-law definition of a real estate professional. Your wife doesn't, because she fails the 750-hour test (she spends only 480 hours in real estate businesses in which she materially participates. However as long as you file jointly, it only takes one qualifying spouse to be eligible for the real estate professional exception. The bottom line: you can currently deduct your tax loss from the rental property.

Example 4: Say you and your husband file jointly. You spend 1,360 hours in your multi-level marketing business, 400 hours in your real estate brokerage business, and 40 hours on your rental property. Together, you do substantially all the work on the rental property. Together, you do substantially all the work on the rental property, which generates tax losses. In this example, you materially participate in both the brokerage business (you pass the 500-hour test) and the rental business (you pass the substantially-all-the-time test). However, neither of you can independently pass the 750-hour test. You just don't spend enough hours in real estate. Therefore, you can't claim the real estate professional exception. The bottom line: your rental property losses remain subject to the PAL restrictions. Rats!

Do This: With a little extra effort, you can change the results in Example 4. For example, if your husband can just log 711 hours in the brokerage business, he will qualify as a real estate professional. He would have 751 hours in real estate businesses in which he materially participates, and that would be over 50 percent of his time spent performing personal services. Now you can currently deduct your rental property losses.

Step 3: Try Again with Aggregation Election

Example 5: You are married and file jointly with your wife. You spend 1,800 hours a year at your job, which has nothing to do with real estate. You and your wife also have percentage ownership interests in 27 different rental real estate properties (duplexes, condos, apartment houses, single family homes, you name it). They all throw off tax losses. Both you and your wife each spend about 10 hours per hear dealing with each property, for a total of 540 hours between the two of you. In addition, your wife spends 525 hours in her real estate brokerage business. In that, she materially participates because she passes the 500-hour test. Unfortunately, since each rental property is treated as a separate business, neither you nor your wife can say you materially participate in any of them. As a result, neither you nor your wife is a real estate professional because neither of you can clear the 750-hour hurdle. Tough luck! All your rental losses are subject to the dreaded PAL restrictions. Crud!

Do This: Elect to aggregate all your rental properties and treat them as a single real estate business. Now you have a total of 540 hours in the aggregated business, and you can pass the material participation test (under the 500-hour rule). Also, your wife can now pass the 50 percent and 750-hour tests. Why? Because she now spends a total of 795 hours in real estate businesses in which she materially participates (525 hours from the brokerage business and 270 hours from the aggregated rental property business). Those 795 hours also amount to more than 50 percent of her personal service hours (100 percent in this example). Therefore, your wife meets the real estate professional definition. Voila! All your rental property losses are now 100 percent deductible. Life is good!

Step 4: Ignore PAL Restrictions and Deduct Your Losses

As explained earlier, each interest in a rental real estate property is considered a separate business unless you make the election to aggregate them and treat them as a single business. But if you choose to aggregate them all. You are not allowed to aggregate some and leave others separate. Most people have to make the aggregation you will see, however, this mandatory "aggregate 'em all rule" can have some negative consequences.

The downside of Aggregation

but if you make the aggregation election after piling up some suspended passive losses, you won't be able to deduct your suspended losses until you unload the last of your rental properties. No big deal when your cumulative suspended losses are minimal. But if you have large suspended losses, you need to think long and hard about the advisability of making the aggregation election. Hmmmm.

So if you have significant suspended passive losses from specific properties that you're likely to sell in the near future, you probably should not make the aggregation election until after you sell.

Also, if your loss properties are inside limited partnerships, making the election may do some harm without doing any good. Why? Because your entire aggregated rental real estate business would become subject to the much-stricter material participation standards for limited partnership interests. This means you will probably still be unable to deduct your current-year losses. Meanwhile, your suspended passive losses from earlier years would be tied up indefinitely -- because of the complete disposition rule -- until you sell all of your rental property ownership interests. In this case, making the aggregation election would be a terrible idea.

The election is also inadvisable if you have some mature rental properties that are throwing off passive income. In this case making the election would convert that passive income into nonpassive income. Bad idea. Having passive income is always good, because it allows you to deduct passive losses. So in this scenario too, you should leave well enough alone and not make the aggregation election.

Finally, say your rental real estate properties are in the aggregate throwing off passive income from other sources. Here you have no need from the aggregation election, because you are already able to currently deduct all your passive rental real estate losses. If you don't need to make the election, don't.

Aggregation Election Procedure

You make the election by including a statement in your original return for a year when you are eligible for the real estate professional exception. If you could have made the election in an earlier year and failed to do so, you are still allowed to make the election in a later year.

Your election statement should look something like this:  Your Name  qualified in  year of election  for relief from the passive activity loss limitation provisions under the special rules for taxpayers in real property trades or businesses. Taxpayer hereby elects to treat all rental real estate activities as a single (aggregated) activity, pursuant to IRC Section 469(c)(7)(A).

Here's how not to make the election. In a recent Tax Court case, the taxpayer claimed he had effectively made the aggregation election by currently deducting all his rental real estate losses on Schedule E of his 1040. "Sorry," said the Tax Court. An affirmative statement (like the one above) is required. No statement means no ability to aggregate one's rental properties. so the taxpayer's hoped-for deductions remained just a bunch of suspended passive losses. Don't let this happen to you. Attach an affirmative election statement to your return.

Finally, Keep Good Records, As Always!

• That you met the material participation standard for one or more real estate businesses, including rental properties (see Step 1). This means keeping daily logs or some other form of proof about the amount of time spent in your real estate activities. Scribbling your time down on a calendar is good enough.
• That you or your spouse independently passed both the 50 percent test and the 750-hour test (see Step 2). Once again, you need records documenting how your time was spent.
• The making the aggregation election got you over the hump, if it did (see Step 3). In other words, keep computations to show that aggregating all your rental real estate activities allowed you to get past Steps 1 and 2.
• That you correctly totaled up the tax losses from the real estate businesses in which you materially participate (including rental properties) and currently deducted that mount on your Schedule # (see Step 4). Once again, keep your computations in case you get audited.