What are the pros and cons of choosing to use active participation rather than passive participation in rental property?

[sallywing]

All the questions and answers I've seen so far tend to push toward the active participation although I've read one that says something about not being able to deduct losses till property is sold.  I know I'm simplifying here, but I would really like to know what the thoughts are behind the decision to take the  active participation status or remain passive (of course, assuming we have the choice).  Thanks much for any explanation.

[Carl]

You really don't have a choice here. For a vast majority, unless renting out property is your primary source of income for the year (meaning more than half) your participation is probably passive. Even if it does provide more than half  your income, your participation could still be passive too, as that's not the sole deciding factor.
If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities.

So basically, unless you are a real estate professional, your participation is passive.  If you read the IRS tax map at https://taxmap.irs.gov/taxmap/pubs/p527-008.htm for IRS Publication 527, that seems to cover it pretty well. A few pointers:

If you own three or less rentals, are not a licensed real estate professional and claim active participation, that will raise flags with the IRS.  So be ready to prove it when the IRS audits you on it. It's not an issue if you can prove it.

[sallywing]

Carl, Thanks so much for your explanation.  That does make the choice I have more clear.  However, why did TurboTax guide me to choose active participation?  And now, of course, I have already efiled.  TT lists questions to answer and then says "Voila!  you are an active participant!"  But it's clear from your explanation and my gut feeling that this was not the right choice.
Sally

[Carl]

More than likely, you mis-read one of the questions concerning active participation and therefore answered it wrong. Also, you may be fine because of specific wording, and actually answered everything right.  
Now, because you have already e-filed and it has been accepted by the IRS, then under no circumstances and with no exceptions, should you change anything "at this point" on your already e-filed and accepted return. If you do, you'll find yourself in a never-ending nightmare with the IRS next year, from which you will never awaken. We're just going to "look" at stuff so I can help you understand and confirm a few things to put your mind at ease.
On the fist screen when you start working through the rental section, but before you actually get to the specific rental property screen, on the screen titled "So far you're not a real estate professional". There are two selections on that screen.
The first selection is checked by you only if you spend more than 750 hours a year directly involved in real estate. Now if you were a licensed Real Estate Agent, that would be an easy "yes" if that was your primary job. But if not, and lets say you only own a single rental property.
750 hours - that's 94 eight hour days - So with 24 mon-fri working days in a month, that's almost 4 months, 5 days a week, 8 hours a day being "directly involved" in the property. I seriously doubt you'd be anywhere even close to that if you only own a single rental.
The 2nd selection checkbox is selected by you only if you spend more than 50% of your working time earning money "directly involved" in real estate activity. Again, if you only have one rental, then that's just flat out not possible unless you spend less than 50% of your time stealing money (literally!) from elsewhere to put food on your table. 🙂

Now, if you made wrong selections and were incorrectly classified as a real estate professional, then do not under any circumstances attempt to change anything at this time. Just let me know and I'll help you fix this the property way so you don't have issues with your 2019 taxes next year.

[sallywing]

Hi Carl.  I am certain I didn't select those incorrectly.  Still, later on it asks again if this is a QBI, as I recall.  It asks if I own more than 10% and if I make major management decisions (both answered yes), and TT tells me I'm an active participant.  At that point, I didn't know whether to accept that or not, and I probably ran it both ways and found no change to my taxes owed.  This is a new rental, my only rental, and of course I have a loss.

I don't know how to get back into my TT questions without saying I want to amend, so the above is from my memory only.  I downloaded all the forms and worksheets; those that indicate QBI say my deduction is zero, as expected.

At the same time, I own this 50%, and the other owner has more rental properties and files as a passive participant.
Sally

[Carl]

There is a difference between active participant, and real estate professional. You are an active participant if you meet the requirements covered by the program. But that doesn't make you a real estate professional. Overall, if you answered the questions honestly, then I to am confident you have nothing to worry about or change.
Basically, on the selection screen that reads "So far, you're not a real estate professional", there are two checkboxes. One for if you spend more than 50% of your work related time involved in real estate, and the other for if you spend more than 750 hours a year involved in real estate. If you did not select both of those options (one option is not sufficient) then you do not qualify as a real estate professional. Again, that RE Pro status has nothing to do with being an active participant.

[sallywing]

OK, but my concern is that it now lists this enterprise as a Qualified Business and my income as QBI.  I have no income (it's a loss for 2018), but the fact that it's listed as QBI--does that do something to the carry-forward amount of my loss?  Do I lose the passive loss carry-forward until I actually sell the property?  It seems there's something regarding this that I read about.

I really do appreciate your taking the time to educate this stranger, Carl.  
Sally

[Carl]

I'm not completely privy to a full understanding of how QBI works with rental property when said property shows a loss on paper, as would be expected as the years pass. Since I paid off one of my three rentals years ago, I have been showing a taxable profit on the rental income for the last few years. Since traditionally property with a mortgage on it shows ever increasing losses on paper year to year that are carried over, I'm not all that clear on how it deals with QBI when the SCH E shows a loss. My unclear understanding is that "something" concerning QBI gets carried over.

[sallywing]

Carl,
We will see how it plays out in 2019.  Fingers crossed we make a little money this time.
Thanks for your help.
Sally

[Carl]

In reality, you do make money with rental property every year. If what you charge for rent covers mortgage, insurance, property taxes and those few repairs and maintenance expenses incurred during the year, anything left over is profit that goes in your wallet.
But when it comes to taxes, it's that depreciation that you are required to take each year by law, that basically "cancels out" the taxability of most (if not all) of what goes in your wallet. So while you may in fact make money, from the income tax perspective, it "appears" on paper that you are losing money.

[sallywing]

Got it.  Of course! (not counting the first year, though)

[aninja750]

Sold my rental property in 2023. Had it for 3 years. Chose active participant as I met the requirements. Did a huge remodel and had many capital improvements (ex. new roof)(not just expenses). But as a result turbotax took my 150k in capital improvement losses> transferred to Schedule 1 Line 4> which transferred to my 1040 Line 8. Then, the 1040 combines my 135k Long term capital gain from SchD >  to1040 Line 7 WITH my investment property capital improvement losses (1040 Line 8).  I have no ordinary or investment income this year so I thought that means I would be in the 0% long term capital gains tax bracket. Form 4797 Sale of Business Property was also used by turbotax. Was it calculated this way because I chose "active participant?" I thought the capital improvements should be with the asset on schedule D and only applied to the cost basis, not offsetting other income. If I change to NOT be active participant, will Turbotax then combine the capital improvement losses with my long term capital gain and NOT carry the losses over to other income on Schedule 1?

Or is it because when they say "the 0% LTCG rate applies if your income for MFJ is less than $89,250" ...that its not talking about just W2 income but they 1st add your long term capital gain to your total income on 1040 line 7, so even with no W2 income, if your long term cap gain from sale of rental property was like $200,000 profit, they would 1st add that to your other income and then you would then be above the $89,250 amount and thus have to pay a long term capital gains rate. Or does the LTCG chart mean that if you had zero w2 income, and $1,000,000,000 in LTCG profit from sale of rental property, you would pay 0% long term capital gains rate???