Taxpayers who make their living in a trade or business related to real property are held to a different standard than other taxpayers when it comes to the rental passive activity loss rules of Sec. 469. Practitioners often misunderstand that the activities that qualify a taxpayer for the favorable treatment may not be the activities that would otherwise be subject to the passive activity loss limitation. Therefore, taxpayers who work in any business related to real property stand a better chance of treating certain otherwise passive activities as nonpassive.
The real estate professional exception to the passive activity loss rules is what creates this double standard. Generally, the passive activity loss rules (Sec. 469) treat rental real estate as a passive activity. As such, rental losses can only reduce passive income. By qualifying for the real estate professional exception, the taxpayer gains the ability to offset rental real estate losses against ordinary and portfolio income. In order to take advantage of the real estate professional exception, the taxpayer must meet three requirements:
- Over 50% of the taxpayer’s personal services during the tax year are performed in real property trades or businesses in which he or she materially participates;
- The taxpayer must perform more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates; and
- The taxpayer materially participates in the rental real estate activity (Sec. 469(c) (7)(B) and Regs. Sec. 1.469-9(e)).
Real Estate Professionals
The first two requirements determine the taxpayer’s status as a real estate professional. They focus on the amount of time spent in real property trades or businesses. The term “real property trade or business” is broadly defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business (Sec. 469(c)(7)(C)). Generally, qualifying taxpayers work as real estate brokers and agents, general and specialty contractors, land developers, property managers, those engaged in property acquisition, etc.
If a taxpayer spends most of his or her time in any of these industries, the activities may qualify unrelated rental properties as a nonpassive activity. Qualified real estate professionals often overlook the fact that they are able to treat their unrelated real estate rentals as nonpassive activities. The rental real estate activities can be completely unrelated to the taxpayer’s other real property trades or businesses and still qualify, as long as the taxpayer and/or his or her spouse materially participates. It is important to note, however, that the 50% and 750-hour requirements must be met separately by one spouse in the case of a joint return.
In addition, no time spent as an employee will qualify unless the taxpayer is more than a 5% owner in that trade or business. In Agarwal, T.C. Summ. 2009- 29, the petitioner was a licensed real estate agent under California law. She worked full time as a real estate agent at Century 21 and as such designated herself as a real estate professional on her tax return. The IRS argued that because the petitioner was not a more than 5% owner of the company, she did not qualify as a real estate professional. This case turned on whether the petitioner was an employee or an independent contractor. The IRS contended that she was an employee of a real estate brokerage company in which she did not own an interest. The taxpayer argued that she was a broker in business for herself. The Tax Court found that she was a self-employed broker and worked as an independent contractor. As such, she qualified as a real estate professional and was able to treat her unrelated material participating rental real estate properties as nonpassive.
After meeting the first two requirements, the taxpayer is considered a real estate professional. However, in order to treat a rental activity as nonpassive, the taxpayer must also materially participate in that rental activity.
The taxpayer will meet the normal criteria for material participation by satisfying one of the seven tests set forth in Temp. Regs. Sec. 1.469-5T(a) and Regs. Sec. 1.469-9(e):
- The taxpayer works more than 500 hours during the year in the activity.
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and participates as much as any other individual.
- The activity is a significant participation activity (SPA), and the sum of all hours worked in the SPAs exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity, and the taxpayer materially participated in that activity in any three of the prior years.
- Based on all the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test applies only if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
These seven tests consider qualitative as well as quantitative aspects. Ultimately, the focus is on the taxpayer’s regular, continuous, and substantial involvement in the activity (Sec. 469(h)(1)). It should be noted that special rules are provided for limited partnerships and closely held C corporations (Sec. 469(h)).
Two factors that may assist in qualifying the taxpayer for material participation include the elective grouping of Sec. 469(c)(7)(A)(ii) and spouse participation. Nongrouped rental activities require the taxpayer to materially participate in each separate rental activity for that activity’s loss to be nonpassive. However, the elective grouping allows the taxpayer to aggregate his or her participation in multiple rental real estate activities; therefore, material participation in one rental will qualify as material participation in all the rentals. The taxpayer must make the election to group on an original return (Regs. Sec. 1.469-9(g)). The taxpayer should make the decision to group with caution because the election is generally binding on all future years.
Spousal participation can also assist the taxpayer in achieving material participation. In the case of a joint return, one spouse alone must separately satisfy the 50% and 750-hour requirements. However, the taxpayer and spouse combined may satisfy the material participation requirement.
Example: T and J are married, and both own real property trades or businesses. T owns a construction company and J owns and manages a condo that they lease out. For most individuals, the condo rental would be a passive activity. T alone qualifies as a real estate professional because he devotes more than 50% of his personal services and 750 hours in his construction business during the tax year, and J materially participates in the condo by providing substantially all the work in the activity. The condo rental will be considered a nonpassive activity because T alone qualifies as a real estate professional and J provides substantially all the work in the rental. Any losses incurred will be nonpassive losses.
Possibly the most overlooked requirement for this exception is documentation. Recordkeeping is an important element for the taxpayer to prove a case to the IRS. In Fowler, T.C. Memo. 2002-223, the taxpayer, owner and president of an air conditioner company, was unable to qualify for the exception because of insufficient documentation. The taxpayer’s documentation amounted to a work order calendar that reported estimated job costs. He did not document the hours worked on each job. The taxpayer went back years later to try to estimate each job’s actual hours, but the IRS argued that this was insufficient. The Tax Court ruled against the taxpayer. In essence, when proving participation in an activity, no hours exist unless they are documented. Thus, it is important that taxpayers document the time spent on their services as well as time and activities performed by others.
The real estate professional exception to passive activity loss rules remains a vehicle to reduce the tax liability of real estate professionals. The key point to remember is that the real estate trade or business activity that allows a taxpayer to qualify may be totally unrelated to the rental activity incurring the loss. Overlooking the broad definition of what constitutes a real property trade or business is also a common misstep in tax planning. Although various hurdles must be met and caveats considered in meeting this exception, qualifying will allow the taxpayer to treat rental real estate losses as nonpassive.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
For additional information about these items, contact Mr. Koppel at (781) 407-0300, or firstname.lastname@example.org.