Gains & Losses
A recently published Chief Counsel Advice (CCA 201504010) provides important guidance addressing whether activities of a real estate broker or mortgage broker are considered activities in a "real property trade or business" for purposes of determining whether the person is a real estate professional under Sec. 469(c)(7). Based on guidance in this CCA, affected taxpayers may need to reevaluate whether they will meet the definition of real estate professional. The results of this analysis may have a significant impact on a taxpayer's treatment of the income from rental real estate activities under Secs. 469 and 1411.
Rental Real Estate Under Sec. 469
Under the general rules of Sec. 469(a), a taxpayer may not use losses from a passive activity to offset other nonpassive income. Sec. 469(c)(1) provides that a passive activity is any trade or business activity in which the taxpayer does not materially participate. Sec. 469(c)(2) provides further, however, that any rental activity (including rental real estate activities) will be considered passive regardless of a taxpayer's participation. In other words, a taxpayer's rental real estate activities are per se passive.
In addition to the loss limitation rules of Sec. 469, Sec. 1411 imposes a net investment income tax on certain items of passive income, including real estate rental income. Specifically, Sec. 1411(c)(1) defines the term "net investment income" to include "rents" unless they are derived from a nonpassive trade or business. Sec. 1411(c)(2) references Sec. 469 in defining a passive activity. Therefore, per se passive rental real estate income would likely be considered net investment income for purposes of the Sec. 1411 net investment income tax.
Sec. 469(c)(7) contains an important exception providing that a taxpayer's eligible rental real estate activities are not treated as per se passive for taxpayers who perform specified levels of services in real property trades or businesses. A taxpayer who qualifies under Sec. 469(c)(7) is commonly referred to as a "real estate professional." Therefore, a taxpayer that is considered a real estate professional will be able to treat a rental real estate activity as nonpassive for purposes of the passive activity loss rules, providing that he or she materially participates in the activity under the rules described in Sec. 469(h)(1). In addition, a taxpayer that is a real estate professional potentially will not be subject to the Sec. 1411 net investment income tax on rental income from the activity if he or she materially participates in the activity and it constitutes a trade or business or the taxpayer qualifies for the safe harbor in Regs. Sec. 1.1411-4(g)(7)(i).
A taxpayer that satisfies the following requirements of the two-prong test under Sec. 469(c)(7)(B) will be considered a real estate professional:
- More than half of the personal services the taxpayer performed in trades or businesses during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates, and
- More than 750 hours of services must be performed by the taxpayer during the tax year in real property trades or businesses in which the taxpayer materially participates.
Sec. 469(c)(7)(C) defines the term "real property trade or business" as "any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, or brokerage trade or business." As these terms are not separately defined in Sec. 469(c)(7)(C) or elsewhere in the Code or regulations, questions often arise as to whether a particular activity constitutes a real property trade or business.
In CCA 201504010, the IRS considered whether two taxpayers conducting different real estate-related activities were engaged in real property brokerage trades or businesses within the meaning of Sec. 469(c)(7)(C). The CCA addressed Taxpayer X, a state-licensed real estate agent working full time as an independent contractor for a real estate brokerage firm, and Taxpayer Y, a state-licensed mortgage broker.
As a real estate agent, Taxpayer X brings together buyers and sellers of real property and negotiates contracts of sale and other agreements between buyers and sellers of real property. As a mortgage broker, Taxpayer Y markets mortgage loans and brings together lenders and borrowers. Under state law, Taxpayer Y's mortgage brokerage business is considered to be a real property brokerage business.
The IRS concluded that absent further guidance, legislative history and principles of statutory construction should apply to determine the meaning of "real property brokerage" for purposes of Sec. 469. In addition, the analysis should be based on federal, not state, law and thus state law definitions of the terms "real estate agent" and "mortgage broker" do not control whether a person is engaged in a real property brokerage trade or business. Following these propositions in its analysis, the IRS found that Taxpayer X, a real estate agent who brings together buyers and sellers of real property, may be engaged in a real property brokerage trade or business under Sec. 469(c)(7)(C). Conversely, Taxpayer Y, a mortgage broker who is involved in the "financing" of real property, is not in a real property brokerage trade or business within the meaning of Sec. 469(c)(7)(C).
Implications of the CCA
Based on the analysis in the CCA, a taxpayer's work as a licensed real estate broker working in a real estate trade or business will be taken into account in determining whether both Sec. 469(c)(7)(B) requirements to be a real estate professional are satisfied. Meeting the real estate professional definition will allow the taxpayer to avoid the per se passive treatment of the activity. This will then give the taxpayer the opportunity to avoid the Sec. 469 passive activity loss rules for the rental real estate activity by meeting the material participation standards of Sec. 469.
Further, as a real estate professional, the taxpayer may be able to avoid treating his or her rental real estate income as net investment income for purposes of Sec. 1411. To do so, the taxpayer would be required to meet the material participation rules of Sec. 469 with respect to the rental real estate activity and it must constitute a trade or business, or the taxpayer would have to qualify for the safe harbor in Regs. Sec. 1.1411-4(g)(7)(i). To qualify for the safe harbor, a taxpayer that is a real estate professional must participate in the rental real estate activity for more than 500 hours during a tax year or have participated in the real estate activity for more than 500 hours in any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year. Under this safe harbor, the rental income from the rental real estate activity will be considered to be income derived in the ordinary course of a trade or business and not included in net investment income.
A licensed mortgage broker, on the other hand, will not be treated as engaged in a real estate trade or business. Therefore, those taxpayers cannot be treated as real estate professionals by virtue of the mortgage brokerage activities. Unless the taxpayer otherwise meets the real estate professional exception (e.g., via other real estate-related activities), the mortgage broker's rental real estate activities will be subject to the passive activity loss rules of Sec. 469. Further, absent otherwise meeting the requirements for the real estate professional exception, income generated from those activities will be treated as net investment income for Sec. 1411 purposes.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.