Navigating the Real Estate Professional Rules

By Tony Nitti, CPA, MST

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EXECUTIVE
SUMMARY

 
  • Under Sec. 469, a taxpayer only may offset losses from a passive activity against income from a passive activity. A passive activity generally includes any trade or business of a taxpayer in which the taxpayer does not materially participate and any rental activities of a taxpayer, regardless of the level of participation.
  • A rental activity of a taxpayer that qualifies as a real estate professional under Sec. 469(c)(7) is not presumed to be passive and will be treated as nonpassive if the taxpayer materially participates in the activity.
  • A taxpayer qualifies as a real estate professional if (1) more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are in real property trades or businesses in which the taxpayer materially participates, and (2) hours spent providing personal services in real property trades or businesses in which the taxpayer materially participates total more than 750 during the tax year.
  • A real estate professional taxpayer generally must establish material participation in each rental activity separately. However, the taxpayer may elect to aggregate all of his or her interests in rental real estate for purposes of determining material participation.
  • Passive income, including from rental activities, is generally subject to the net investment income tax (provided other criteria are met) unless the taxpayer is a qualifying real estate professional and the income is derived in the ordinary course of a trade or business.
  • A safe harbor in such cases provides that 500 hours in the rental activity either in the tax year or in any five years (whether or not consecutive) of the immediately previous 10 years constitutes services in the ordinary course of a trade or business.

Sec. 469 provides that losses from a "passive activity" may only be used to offset income from a passive activity, with any passive losses in excess of passive income for a tax year disallowed and carried forward to the next year. Included in the definition of a passive activity is any rental activity, regardless of the taxpayer's level of participation.

A taxpayer who meets the qualification of a real estate professional under Sec. 469(c)(7), however, overcomes the presumption that all rental activities are passive. As a result, since the enactment of Sec. 469(c)(7) in 1993,1 taxpayers with rental losses have sought to meet the qualification of a real estate professional to prevent those losses from being treated as per se passive, potentially allowing the losses to be used without limitation.

On Jan. 1, 2013, qualifying as a real estate professional suddenly became meaningful even to taxpayers with rental income. On that date, the net investment income tax of Sec. 1411 became effective, levying an additional 3.8% surtax on, among other items of investment income, all passive income of a taxpayer. Thus, a taxpayer with rental incomenow has an incentive to qualify as a real estate professional: characterizing rental income as nonpassive to avoid imposition of the surtax.2

As a result, it has never been more desirable for a taxpayer with rental activities to meet the qualification of a real estate professional. Unfortunately, qualifying as a real estate professional is fraught with peril. The various terms of art, hours requirements, and quantitative tests imposed under Sec. 469(c)(7) and the underlying regulations have confused taxpayers, tax advisers, IRS agents, and even Tax Court judges, leading to an inordinate amount of litigation during the 24-year history of the provision.

This article seeks to clear up the confusion surrounding these rules by providing a step-by-step approach that tax advisers can use to determine whether a taxpayer qualifies as a real estate professional and, more importantly, if the taxpayer does qualify, whether his or her rental activities are treated as nonpassive. While discussing each step, this article reviews case law, highlighting planning opportunities and traps for the unwary. This article also discusses an important recent Chief Counsel Advice (CCA) in which the IRS revealed that it had previously misapplied a vital aspect of the real estate professional rules.

History of the Real Estate Professional Rules


The Passive Activity Rules in General

Prior to passage of the Tax Reform Act of 1986,3 tax shelters were readily available to any taxpayer with disposable income and the willingness to be a landlord. Consider the following example:

Example 1: In 1985, A, a doctor, earns wages from a medical practice of $300,000. In hopes of sheltering his wage income, A purchases a home and rents it at fair market value. The rental is low-maintenance; A is rarely required to visit the property and otherwise spends little time managing its rental. By virtue of large depreciation deductions, the rental generates a tax loss, which A uses to partially offset his wage income, significantly lowering his tax bill. The situation is a win-win for A; he generates losses largely through noncash depreciation deductions while the rental home appreciates in value.

The Tax Reform Act of 1986 put an end to such shelters, however, by enacting Sec. 469. Effective for tax years beginning after Dec. 31, 1986, a taxpayer's loss from a passive activity can only offset income from a passive activity.4 The definition of a passive activity includes any rental activity of the taxpayer, regardless of the taxpayer's level of participation (but with an exception discussed below).5

As a result of the categorization of all rental activities as passive, the doctor's loss in Example 1 from his rental home would be passive. Because the doctor's wages are not passive income,6 Sec. 469 will not permit the rental loss to offset the doctor's wage income. Instead, the loss will be carried forward until the doctor either generates passive income or disposes of the rental property in a fully taxable transaction.7

The Real Estate Professional Exception

After the enactment of Sec. 469 but before the addition of Sec. 469(c)(7), certain taxpayers believed they were being unfairly punished by the classification of all rental activities as per se passive. Consider the following example:

Example 2: B is a real estate developer specializing in the development of residential properties. B builds development 1 and development 2. B sells all of the homes in development 1 to customers as part of his ordinary trade or business. The homes in development 2, however, B holds and rents to families.

While B's development business generally would be considered one trade or business, as initially enacted, Sec. 469 treated B as conducting two separate activities for its purposes. The first activity is B's development and sale activity, which is nonpassive because it is a trade or business in which B materially participates. The second activity is B's development and rental activity, which under the rules of Sec. 469 is treated as per se passive regardless of B's level of participation because it is a rental activity. Thus, if B generated income from the sale of homes in development 1 and a loss from the rental of homes in development 2, before the addition of Sec. 469(c)(7), Sec. 469 generally prohibited B from using the passive rental losses to offset the nonpassive income from the sale of the homes in development 1.

B complains, of course, that he is engaged in one trade or business that encompasses multiple aspects of the real estate industry: development, sale, and rental. By not allowing B to use the losses from the rental portion of the business against income from the sale portion of the business, the law treated B differently from taxpayers in non—real estate trades or businesses, who could use losses from one aspect of their business against income from another.

By 1993, Congress recognized the inequities wrought by the per se passive treatment of all rental activities and sought to provide an exception to a narrow category of taxpayers: so-called real estate professionals. Congress added Sec. 469(c)(7), by which a taxpayer who qualifies as a real estate professional overcomes the presumption that all rental activities are passive. If the qualifying real estate professional establishes that he or she materially participates in a rental activity, the activity will be nonpassive.

General Rules


Sec. 469 defines a passive activity, in part, as:

  1. Any trade or business of the taxpayer in which the taxpayer does not materially participate,8 and
  2. Any rental activity of the taxpayer except as provided under Sec. 469(c)(7).9

Congress could have simply applied the material-participation standard to rental activities, as it did to all other trades or businesses, but chose not to for two reasons. First, even rental activities that yield positive cash flow often generate a tax loss due to depreciation deductions, making rental properties an ideal tax shelter.

Second, as discussed later in this article, a taxpayer can materially participate in an activity other than real estate rental by performing only minimal personal services, provided no other individual contributes services to the activity. While most trades or businesses require a meaningful time commitment, many rental activities are so low-maintenance that a taxpayer can conduct them with very little effort. As a result, if Congress had permitted a rental activity to qualify as nonpassive via the same material-participation standard as for other activities, many taxpayers who invested minimal time in their rental properties would meet this standard, greatly hindering Congress's ability to curb the use of rental activities as tax shelters.

As a result, a taxpayer can overcome the presumption that all rental activities are passive if the taxpayer qualifies as a real estate professional by satisfying the two quantitative tests of Sec. 469(c)(7)(B):

  1. More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
  2. The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

It is a common misconception, however, that qualifying as a real estate professional makes the taxpayer's rental activities nonpassive. This is not the case; rather, a taxpayer who qualifies as a real estate professional has merely overcome the presumption that all rental activities are passive regardless of level of participation. For the real estate professional's rental activities to become nonpassive activities, the taxpayer must establish that he or she has met the material-participation standard with regard to the rental activities.10 Only those rental activities in which the real estate professional materially participates are nonpassive activities.

Importantly, the statute provides that a qualifying real estate professional must establish material participation in each separate rental activity.11 An exception is provided, however, by which the taxpayer may elect to aggregate all interests in rental real estate for purposes of measuring material participation.12 As is discussed later in this article, this election to aggregate all rental activities of a qualifying real estate professional has been perhaps the most misunderstood aspect of the real estate professional rules and a major source of controversy between taxpayers and the IRS.

Steps to Qualify as a Real Estate Professional


The following steps should be followed to determine whether a taxpayer first qualifies as a real estate professional, and if so, whether the taxpayer's rental activities are nonpassive:

Step 1: Identify and group the taxpayer's real property trades or businesses.

Step 2: Identify the taxpayer's real property trades or businesses in which the taxpayer material participates.

Step 3: Total the hours of participation in those real property trades or businesses in which the taxpayer materially participates. If the taxpayer is married, only count the hours from the spouse seeking to qualify as a real estate professional.

Step 4: Apply the hours from Step 3 to the two quantitative tests of Sec. 469(c)(7)(B):

  1. Do the hours represent more than one-half of the total personal service hours the taxpayer performed during the year in all trades or businesses?
  2. Do the hours exceed 750?

Step 5: A taxpayer who passes both tests in Step 4 is a qualifying real estate professional. The qualifying real estate professional must next establish material participation in his or her rental activities.

  1. Does the taxpayer materially participate in each separate rental activity?

    Each rental activity in which a qualifying real estate professional materially participates is nonpassive. Any rental activity in which the taxpayer fails to materially participate, however, is passive despite the taxpayer's qualification as a real estate professional.13

    As an alternative, a qualifying real estate professional may elect to aggregate all of his or her rental activities for purposes of establishing material participation.

  2. If the taxpayer elects to aggregate all rental activities, does the taxpayer materially participate in the combined activity?

If the taxpayer materially participates in the combined rental activities, all of the rental activities are nonpassive. If the taxpayer fails to materially participate in the combined activity, all of the rental activities will remain passive.

A detailed discussion of each step follows, highlighting traps for the unwary and planning opportunities, as illustrated by case law and IRS rulings.

Step 1: Identify and Group the Taxpayer's Real Property Trades or Businesses

Congress intended to limit the reach of the real estate professional exception to taxpayers who work predominantly in the real estate industry. This is accomplished by requiring the taxpayer to qualify as a real estate professional by performing services in a real property trade or business.

The statute lists 11 types of real property trades or businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.14 Additional guidance on what constitutes a real property trade or business is limited. In CCA 201504010, the IRS ruled that a mortgage broker was not engaged in a real property trade or business, noting that (1) a mortgage broker merely puts together lenders and borrowers, an activity that is only tangentially related to real estate, and (2) although Congress had included finance activities in its original list of qualifying real property trade or business activities, it removed them in the final draft of the House bill that enacted Sec. 469(c)(7).

The relevant case law is only slightly more illuminating. In Agarwal,15 the Tax Court held that a California real estate agent who was not a licensed broker under state law was engaged in a real property trade or business because she was engaged in the same activity—putting together buyers and sellers of real property—as a fully licensed broker.

In Calvanico,16the IRS and Tax Court treated a licensed real estate appraiser who worked for a public accounting firm as engaged in a real property trade or business. While this would suggest that a lawyer or accountant who works predominantly with real estate clients is engaged in a real property trade or business, the IRS considers that in these situations, the taxpayer is only tangentially working in the real estate industry and thus is not engaged in a real property trade or business.17 The opposite conclusion was reached in Calvanico likely because, rather than merely working with real estate clients, the taxpayer worked directly in the real estate industry by performing appraisals.

In Stanley,18 the taxpayer owned and worked for a real estate management company that managed his many rental properties. He also served as general counsel for the management company. The IRS argued that the taxpayer could not count the hours spent performing services as general counsel toward the real estate professional tests, because these hours were spent providing legal services rather than providing services related to the management company's real estate business. The District Court for the Western District of Arkansas, however, held that the taxpayer's hours spent providing legal services counted toward satisfying the real estate professional tests, because "Section 469 does not . . . require that the service performed in a real property trade or business be of any specific character or that all such services must be directly related to real estate. Rather, the services must simply be performed 'in real property trades or businesses in which the taxpayer materially participates.' "19

This would seem to provide an avenue for any taxpayer employed by a real estate management company, even a taxpayer who does not directly perform real estate work, such as a receptionist or bookkeeper, to be considered engaged in a real property trade or business.20

The regulations provide an important opportunity for taxpayers seeking to qualify as a real estate professional, stating, "Depending on the facts and circumstances, a real property trade or business consists either of one or more than one trade or business specifically described in section 469(c)(7)" (emphasis added).21

This permits a taxpayer to informally group together, if supported by the facts and circumstances, two or more of the 11 activities listed in the statute into one real property trade or business.22

The IRS embraced this concept in CCA 201427016. In it, the IRS permitted a taxpayer with a real property development trade or business and two rental properties to treat the three activities as one real property trade or business.

In addition, in Miller,23 the taxpayer was engaged in both construction and rental activities. The Tax Court, in measuring the taxpayer's hours spent in real property trades or businesses, combined the hours spent on both activities, effectively treating them as one real property trade or business.

This permitted grouping is advantageous because in Step 2, a taxpayer is required to establish material participation in his or her real property trades or businesses; thus, the more of the taxpayer's activities that can be consolidated into one real property trade or business, the more likely that the combined hours spent on that grouped business will satisfy the material-participation standard.

Example 3: A is a real estate broker who also owns three rental properties. For other purposes of Sec. 469, A would be considered engaged in four separate activities. For the purposes of qualifying as a real estate professional, however, if the facts and circumstances warrant, A may treat her brokerage activity and three rental properties as one real property trade or business. This would allow A to measure the combined hours spent on the brokerage business and the three rental properties to establish that she materially participates in the combined real property trade or business.

Step 2: Identify the Real Property Trades or Businesses in Which the Taxpayer Materially Participates

The taxpayer must next establish material participation in the real property trade or businesses the taxpayer has identified in Step 1. Only the hours spent in those real property trades or businesses in which the taxpayer materially participates will be counted toward the two quantitative tests of Sec. 469(c)(7)(B).

To materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis.24 In turn, the regulations offer seven quantitative tests that may be used to satisfy the standard, providing that a taxpayer will be treated as materially participating in an activity—in this case, a real property trade or business—if:25

  1. The individual participates in the activity for more than 500 hours during the tax year.
  2. The individual's participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
  3. The individual participates in the activity for more than 100 hours during the tax year, and the individual's participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
  4. The activity is a significant participation activity for the tax year, and the individual's aggregate participation in all significant participation activities during the year exceeds 500 hours;26
  5. The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
  6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
  7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

There are several important considerations when measuring material participation in a taxpayer's real property trade or business.

First, hours spent as an employee are not counted unless the employee is a 5% owner in the employer.27 In Calvanico28and Pungot,29 the taxpayers were denied real estate professional status because they did not own the required 5% of their respective employers, and as a consequence, the hours spent in their real property trades or businesses did not count toward material participation.

Hours spent as an investor in a real property trade or business—such as studying and reviewing financial statements, preparing summaries of the finances or operations, or managing the finances of an activity in a nonmanagerial capacity—are not counted toward material participation unless the taxpayer is directly involved in the day-to-day management of the business.30

In addition, if the taxpayer holds an interest in a real property trade or business through a limited partnership interest, the taxpayer may establish material participation only by satisfying the first, fifth, or sixth tests of the seven tests from the regulations described above.31

When measuring material participation, a married taxpayer is required to count any hours performed by his or her spouse, even if the spouse does not own an interest in the business or if no joint return is filed.32 While this rule is advantageous because it makes it more likely the taxpayer materially participates in the real property trade or business, it is a trap for the unwary in the real estate professional context, as discussed below in Step 3.

Example 4: A is a real estate broker who also owns rental properties 1 and 2. A treats her brokerage activity as one real property trade or business and the combined rentals of properties 1 and 2 as a second real property trade or business. A materially participates in her brokerage trade or business by spending 500 hours in the activity. A spends 200 hours on her rental properties; one may assume this would not be enough to materially participate. A's husband, B, however, spends another 305 hours on the rentals. A must count B's hours in determining whether A materially participates in the rental activities. Because A and B combine to spend 505 hours on the rental real property trade or business, A materially participates in the rental real property trade or business.

The regulations provide that the extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of the participation may be established by other reasonable means. Reasonable means include but are not limited to identifying services performed over time and the approximate number of hours spent performing them during that period, based on appointment books, calendars, or narrative summaries.33

The courts, while recognizing that contemporaneous records are not required, have repeatedly held that the IRS is not required to accept a noncontemporaneous "ballpark guesstimate."34 As will be discussed in Step 4, the flexibility afforded taxpayers to record hours retroactively often serves as their undoing.

Step 3: Total the Hours From Real Property Trades or Businesses in Which the Taxpayer Materially Participates

Next, the taxpayer totals the hours spent in those real property trades or businesses in which the taxpayer materially participates. The statute makes clear, however, that while a married taxpayer includes the hours of his or her spouse in determining whether the taxpayer materially participates in a real property trade or business, the taxpayer must pass the two quantitative tests of Sec. 469(c)(7)(B) using only his or her own hours.35

Example 5: Continuing Example 4, while A is required to count the 305 hours spent by her husband, B, in Step 2 for purposes of determining whether A materially participates in the rental real property trade or business, meeting the material-participation standard simply allows A to include that real property trade or business in Step 3. When she does, however, A may include only the 200 hours she spent on the rental real property trade or business; the 305 hours spent by her husband, B, must be disregarded. As a result, A may count only the 500 hours spent in her brokerage real property trade or business and the 200 hours she spends in her rental real property trade or business. This brings her total hours spent in real property trades or businesses in which she materially participates to 700, which will fail the 750-hour requirement of Step 4.

Step 4: Apply the Hours From Step 3 to the Two Quantitative Tests of Sec. 469(c)(7)(B)

Test 1: Do the taxpayer's hours as calculated in Step 3 represent more than half of the total personal service hours the taxpayer performed during the year in all trades or businesses?

The first quantitative test of Sec. 469(c)(7)(B) reserves the benefit of real estate professional status for taxpayers who perform the majority of their personal service hours in real property trades or businesses in which they materially participate.

The relevant case history has established that it is very difficult for a taxpayer who has a full-time job that is not in a real property trade or business to satisfy this first test. The IRS and the courts find it dubious when a taxpayer who works 2,000 hours a year at a non—real estate job purports to have spent more time on his or her real estate activities.

In practice, this more-than-half requirement, when coupled with a taxpayer's recording his or her hours after the fact, has often led to taxpayers' claiming incredibly high numbers of real property trade or business hours while downplaying the hours spent in non—real property trades or businesses.

In Hassanipour,36 the taxpayer was a full-time research associate employee who, according to payroll records, spent 1,936 hours at his job during the tax year. The taxpayer argued, however, that he worked only 1,610 hours at the job and more than 1,682 hours managing his 28 rental properties and 150 to 200 hours more on a rental vacation home in which he held a 50% interest. The court sided with the IRS in determining that he did not spend more time on rental activities than on his research job, finding that the taxpayer's records were not credible and often duplicative.

In Escalante,37 a schoolteacher who owned several rental properties attempted to minimize his teaching hours by recording only the hours school was in session, failing to include any time spent grading papers, attending meetings, etc. The court held that the teaching hours were not reasonable and that the taxpayer also grossly overstated his rental hours, sometimes recording more than 24 hours in a day.

In Lee,38 the court held that the brother of an IRS agent greatly overstated the hours spent managing his rental properties. The taxpayer recorded 24 hours to replace four window blinds, 56 hours to replace a toilet, and 280 hours to close the accounting books of the rental properties, among totals the Tax Court found to be unreasonable.

In all three of these cases, the court held that the taxpayers' records were mere ballpark guesstimates or otherwise not credible, and thus the taxpayers could not establish that they passed the first test of Sec. 469(c)(7)(B). As a result, in each case, the taxpayer failed to qualify as a real estate professional.

In Miller,39 however, a taxpayer who worked full time as a commercial boat pilot was able to satisfy the court that he spent more time on his construction work and rental properties. He kept credible, contemporaneous logs while also having witnesses testify to his extraordinary work ethic.

Test 2: Do the taxpayer's hours from Step 3 exceed 750?

The second quantitative test of Sec. 469(c)(7)(B) requires the taxpayer to work 750 hours in real property trades or business in which he or she materially participates. This prevents a taxpayer who has only real property trades or businesses—and thus will always pass the more-than-half test—from qualifying as a real estate professional despite minimal time spent on real property trades or businesses.

As with the first test, cases reveal that taxpayers' records—or lack thereof—often spell their doom. In Moss,40in attempting to satisfy the 750-hour standard, the taxpayer argued that he should be permitted to include hours spent "on call," when a tenant could contact him if necessary. The court concluded, however, that because the taxpayer was not actually performing services during those hours, the time could not be counted toward the 750-hour requirement.

In Harnett,41 a taxpayer who struggled to satisfy the 750-hour standard contended that he musthave met the threshold because he owned so many properties and they were very valuable. The Tax Court held against the taxpayer, however, stating that the taxpayer had not established he spent the required 750 hours managing them.

Two recent cases, however, show that the courts—if not the IRS—will afford some leniency to taxpayers in meeting the 750-hour requirement. In Lewis,42a disabled military veteran did not provide a contemporaneous daily report of the hours he spent managing his rental property. At trial, however, he credibly testified to his daily routine, and the court determined what it believed to be a reasonable number of hours for the services provided and found that they exceeded 750.

Similarly, in Leyh,43 a taxpayer recorded only 632.5 hours on her time log but explained during audit that she had failed to record the time spent traveling among her 12 rental properties. The IRS countered that her log was inclusive of travel time, but based on her testimony at trial, the court found that she had not included travel time in the time log. After adding the travel time claimed by the taxpayer to the hours from her daily log, the total hours exceeded 750.

Step 5: Establish Material Participation in Each Separate Rental Activity, Unless an Election Is Made to Aggregate All Rental Activities

A taxpayer who satisfies the two tests of Step 4 is a qualifying real estate professional. It is critical to recognize, however, that merely qualifying as a real estate professional does not accomplish the ultimate goal of converting a taxpayer's rental activities from passive to nonpassive.44 Rather, by qualifying as a real estate professional, the taxpayer has merely overcome the presumption that all rental activities are per se passive regardless of the level of participation. Converting the activities to nonpassive requires an additional step: The taxpayer must establish that he or she materially participates in each separate rental activity.45

For any rental activity in which the qualifying real estate professional can establish material participation through the tests discussed in Step 2, the activity becomes nonpassive. For any activity for which the taxpayer cannot establish material participation, however, the activity remains passive, despite the taxpayer's qualification as a real estate professional.46

In establishing material participation in a rental activity, a taxpayer may count hours spent working in a real estate management company even if the company does not directly hold any rental real estate, but only to the extent the work performed by the taxpayer in the management company is spent managing the taxpayer's own rental real estate interests.47

The statute and regulations provide an exception to the general rule that a qualifying real estate professional must measure material participation in each rental activity separately. Under this exception, a qualifying real estate professional may elect to aggregate all of the taxpayer's rental activities for purposes of testing material participation.48 This election, while advantageous, is rife with traps for the unwary and has historically been misunderstood by taxpayers, tax advisers, the IRS, and even the Tax Court. The ensuing discussion highlights the major issues surrounding the aggregation election of Regs. Sec. 1.469-9(g).

Understanding the Regs. Sec. 1.469-9 Aggregation Election

A qualifying real estate professional may elect to aggregate onlyhis or her rental activities. Any nonrental activity is not included in the grouping, and thus the hours spent in the nonrental activity do not count toward material participation. In Bailey,49one of the purported rental activities included in the taxpayer's grouping election had an average period of customer use of less than seven days, which removed the activity from the definition of a rental activity under Sec. 469.50 Thus, the Tax Court held that the hours spent in that activity could not be counted toward the taxpayer's material participation in his rental activities.

A qualifying real estate professional who intends to aggregate all rental activities must make a formal election; merely aggregating all of the taxpayer's rental activities into one column on Schedule E, Supplemental Income and Loss, of Form 1040, U.S. Individual Income Tax Return, does not satisfy this requirement.51 A qualifying real estate professional makes the election to aggregate all interests in rental real estate by filing a statement with the taxpayer's original income tax return for the tax year. This statement must contain a declaration that the taxpayer is a qualifying real estate professional for the tax year and is making the election pursuant to Sec. 469(c)(7)(A).

A taxpayer may revoke the election only in the tax year in which a material change in the taxpayer's facts and circumstances occurs or in a subsequent year in which the facts and circumstances remain materially changed from those in the tax year for which the election was made. To revoke the election, the taxpayer must file a statement with the taxpayer's original income tax return for the year of revocation. This statement must contain a declaration that the taxpayer is revoking the election under Sec. 469(c)(7)(A) and an explanation of the nature of the material change.52

This election is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying real estate professional, even if in intervening years the taxpayer is not a qualifying taxpayer. The election may be made in any year in which the taxpayer is a qualifying real estate professional, and the failure to make the election in one year does not preclude the taxpayer from making it in a subsequent year. In years in which the taxpayer is not a qualifying real estate professional, the election will not have effect.53

The IRS has provided relief allowing certain qualifying real estate professionals to make late elections to aggregate all interests in rental real estate. Rev. Proc. 2011-34 applies to a taxpayer who failed to file a timely election to aggregate but who has filed tax returns consistent with having made the election for all tax years for which he or she is seeking late relief. A taxpayer seeking relief under Rev. Proc. 2011-34 must attach the election required by Regs. Sec. 1.469-9(g) to an amended return for the most recent tax year. The election must identify the tax year for which the taxpayer seeks the late election and must explain the reason for failing to file a timely election. Taxpayers who have filed returns as if they made an aggregation election but who have no record of having made a formal aggregation election as required by Regs. Sec. 1.469-9(g) often use late relief as a protective measure.

Example 6: A filed tax returns for 2012, 2013, 2014, and 2015 reporting his rental activities as if he were a qualifying real estate professional. In addition, A determined whether he materially participated in his rental activities as if he had made an election to aggregate all of his rental activities; however, A can find no record of having filed a formal election with his tax return. A may use Rev. Proc. 2011-34 to file a late aggregation election by amending his 2015 return and attaching the election in accordance with the revenue procedure, indicating that he intends the election to be effective starting Jan. 1, 2012.

If the election is made and at least one interest in rental real estate is held by the qualifying real estate professional in a limited partnership interest, the combined rental real estate activity will be treated as a limited partnership interest for purposes of determining material participation. Accordingly, the taxpayer will not materially participate in the combined rental real estate activity unless the taxpayer satisfies the first, fifth, or sixth tests above in Step 2.54 If, however, the taxpayer's share of gross rental income from all of the taxpayer's limited partnership interests in rental real estate is less than 10% of the taxpayer's share of gross rental income from all of the taxpayer's interests in rental real estate for the tax year, this rule does not apply, and the taxpayer may determine material participation under any of the tests listed in Step 2 that apply to rental real estate activities.55

If a qualifying real estate professional makes the election to aggregate all rental activities for purposes of measuring material participation, the combined rental real estate activity is treated as a single activity for all purposes of Sec. 469, including the disposition rules of Sec. 469(g). Ordinarily, Sec. 469(g) allows a taxpayer to deduct any suspended passive losses attributable to an activity when substantially all of the activity is sold in a fully taxable transaction. When a qualifying real estate professional elects to aggregate all rental activities, however, because the combined rental activity is treated as one activity for purposes of Sec. 469(g), passive losses attributable to a disposed activity are not freed up until substantially all of the combined rental activity is sold.

Example 7: A has rental properties U, V, and W. U has $30,000 of suspended passive losses. In 2016, A is a real estate professional and elects to group U, V, and W together under Regs. Sec. 1.469-9. As a result, U, V, and W are treated as one activity for all purposes of Sec. 469, including Sec. 469(g). In 2016, A sells property U in a fully taxable disposition. A cannot deduct the suspended losses attributable to U (in excess of the gain recognized on the sale) because A has not sold substantially all of the combined activity of U, V, andW.

This election to aggregate all rental activities under Regs. Sec. 1.469-9 differs from other grouping elections provided for in Sec. 469, such as the grouping of trade or business activities under Regs. Sec. 1.469-4, in two important ways. First, the aggregation election of Regs. Sec. 1.469-9 is available only to taxpayers who have satisfied the tests of Sec. 469(c)(7) and thus qualified as a real estate professional. In addition, the aggregation election is all or nothing—either all of the rental activities are aggregated or none are. As a result, if a taxpayer makes the election and acquires an additional rental property in a subsequent year, the new property automatically joins the prior grouping.

In the past, the IRS has made the error of placing undue importance on the aggregation election by considering whether the taxpayer made the election in determining whether the taxpayer meets the definition of a real estate professional. In CCA 201427016, however, the IRS conceded that the election is available only for those taxpayers who have already qualified as a real estate professional, and its use is limited to determining whether the qualifying real estate professional materially participates in his or her rental activities.

Unfortunately, the Tax Court has accepted an improper argument set forth by the IRS on this point in previous decisions,56 as illustrated in this example.

Example 8: A owns five commercial rental properties. He spends 600 hours on property A, 300 on property B, 300 on property C, 250 on property D, and 300 on property E. A performs no other services throughout the year. Assume that under Temp. Regs. Sec. 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in properties B, C, D, or E (i.e., he satisfied one of the other six tests for those four properties). A does not elect to aggregate the five rental properties under Regs. Sec. 1.469-9.

In the past, the IRS has argued that because A did not elect to aggregate the five rental properties, he must satisfy the two quantitative tests of Sec. 469(c)(7)(B)—the more-than-half and 750-hour tests—for each separate rental property. Because A does not spend 750 hours in any one rental property, the IRS would assert that A fails to qualify as a real estate professional and his rentals remain passive.

As conceded by the IRS in CCA 201427016, this argument is incorrect. The aggregation election applies only after a taxpayer has qualified as a real estate professional, and only for the purpose of measuring material participation in the qualifying real estate professional's rental activities.

Continuing the previous example, because A (1) materially participates in his rental real property trade or business by virtue of the 1,750 hours he spends on the rentals, and (2) satisfies the two tests of Sec. 469(c)(7), he qualifies as a real estate professional. And because A materially participates in each rental activity even in the absence of an aggregation election, each rental activity is nonpassive.

Case Study


To illustrate the application of these steps to a real-world fact pattern, consider the following case study:

A is a real estate broker who works part time for a local firm as an independent contractor. She spent 500 hours working for the firm in 2016. In addition, A also took a part-time job as a cashier at a local clothing store, where she worked 600 hours during 2016.

A also owns three rental properties and spent 200 hours performing personal services on each rental property during 2016, including negotiating leases and meeting prospective tenants. She uses a management company, however, to collect the rents, arrange repairs, and handle many other aspects of the rental process. An individual at the management company spent 250 hours on each rental during 2016. The rentals each produce a loss.

Is A a real estate professional?

Are A's rental losses passive or nonpassive?

Step 1: Identify and group the taxpayer's real property trades or businesses: A is engaged in three trades or businesses for purposes of Sec. 469: She is a real estate broker and a landlord and works at a retail store. Only the brokerage business and rental business meet the statutory definition of a real property trade or business. Based on her specific facts and circumstances, A may determine that because her brokerage and rental businesses are interrelated, they make up only one real property trade or business, and she may informally group the two together as provided in the regulations. This will help A in Step 2 to satisfy the material-participation standard with regard to the real property trade or business.

Step 2: Identify real property trades or businesses in which the taxpayer material participates: A spent 500 hours working as a broker. Because A is an independent contractor rather than an employee, she is not required to own 5% of her employer to count those hours toward material participation. A spent 600 hours on her rentals, for a total of 1,100 hours in her combined brokerage and rental real property trade or business. This exceeds 500 hours and thus satisfies the first of the seven material-participation tests. As a result, A may count the 1,100 hours in Step 3.

Step 3: Total the hours from real property trades or businesses in which the taxpayer materially participates: If the taxpayer is married, only the hours from the spouse seeking to qualify as a real estate professional may be counted.

A is not married. Her total hours spent in real property trades or businesses in which she materially participated for 2016 are 1,100.

Step 4: Apply the hours from Step 3 to the two quantitative tests of Sec. 469(c)(7)(B):

  1. Do the hours represent more than half of the total personal service hours the taxpayer performed during the year in all trades or businesses?

    A spent 1,100 hours in real property trades or businesses in which she materially participated and another 600 hours in a retail business that is not a real property trade or business. Thus, A spent 1,100 of 1,700 hours in real property trades or businesses in which she materially participated and passes the first quantitative test of Sec. 469(c)(7)(B).

  2. Do the hours exceed 750?

A's 1,100 hours spent in real property trades or businesses in which she materially participated exceed 750; thus, A satisfies both tests of Sec. 469(c)(7)(B) and qualifies as a real estate professional.

Step 5: Establish that the real estate professional materially participates in the rental activity:

  1. As a general rule, the taxpayer must materially participate in each separate rental activity.

    While A was permitted to informally group her three rental activities for purposes of determining her real property trades or businesses, now that she has satisfied the real estate professional tests, as a general rule, A must establish that she materially participates in each separate rental activity. While A spent 200 hours in each activity, because another person spent more hours on each activity—the employee at the management company—A does not materially participate in any of the three rentals. As a result, despite the fact that A is a real estate professional for 2016, each rental activity remains passive.

  2. The taxpayer may elect, however, to aggregate all rental activities—and only rental activities—in which case the taxpayer measures material participation on an aggregate basis.

If A makes a formal election under Regs. Sec. 1.469-9(g) to aggregate her three rental activities, she may combine her hours spent in the three activities for purposes of establishing material participation. Because A spent 600 hours in the combined activities, A satisfies the first of the seven tests under Temp. Regs. Sec. 1.469-5T(a). As a result, all three of A's rental activities are nonpassive in 2016, and A may deduct the losses without limitation.

Net Investment Income Tax Implications


For tax years beginning on or after Jan. 1, 2013, taxpayers must pay an additional 3.8% tax on the lesser of (1) net investment income or (2) the excess of the taxpayer's modified adjusted gross income over the applicable threshold ($250,000 if married filing jointly, $125,000 if married filing separately, and $200,000 if single).57

Included in the definition of net investment income is all income from a passive activity.58 Because, as previously discussed, as a general rule, all rental activities are per se passive, all rental income will generally be included within the definition of net investment income. Although, as discussed above, real estate professionals may overcome that presumption by materially participating in the activity, this does not guarantee that the income will escape the net investment income tax. Rather, the Sec. 1411 regulations exclude nonpassive rental income from net investment income only if it is earned "in the ordinary course of a trade or business."59

The regulations provide a safe harbor by which a qualifying real estate professional with nonpassive rental income may meet the requirement that the rental income is derived in the ordinary course of a trade or business. To satisfy the safe harbor, the taxpayer, in addition to qualifying as a real estate professional and materially participating in his or her rental activities, must spend 500 hours in the rental activity either for the year or in any five years (whether or not consecutive) of the immediately previous 10 years.60 The effect of satisfying the safe harbor is not only to remove any rental income from the definition of net investment income but also to remove from net investment income any gain from the sale of the rental property.61

If the qualifying real estate professional elects under Regs. Sec. 1.469-9(g) to aggregate all rental activities for purposes of measuring material participation, the election also applies for purposes of meeting this 500-hour net investment income safe harbor. Because it is unreasonable to expect that a taxpayer with multiple rental activities will spend 500 hours in each activity, the aggregation election becomes even more critical when the taxpayer's rental activities produce income rather than losses.62 To illustrate, consider the following example:

Example 9: A is a full-time real estate broker with three rental activities. A spends 200 hours on each rental, and no other person contributes more. A qualifies as a real estate professional, and because she materially participates in each separate rental activity, the activities are nonpassive even in the absence of an aggregation election.

If the activities produce income, however, and A fails to make the aggregation election, the income would remain subject to the net investment income tax because A does not spend 500 hours in any of the separate activities and thus does not satisfy the regulatory safe harbor. If A makes the aggregation election, however, A spends 600 hours in the combined rental activity and satisfies the safe harbor. As a result, the rental income will be treated as having been earned in the ordinary course of a trade or business and thus will not be included in A's net investment income for purposes of the 3.8% surtax of Sec. 1411.

Conclusion


Meeting the definition of a real estate professional is important for all taxpayers with rental activities because a taxpayer who does so overcomes the presumption that all rental activities are passive. If the taxpayer further establishes material participation in the rental activities, the rental activities will be nonpassive; as a result, the taxpayer may use any rental losses without limitation and may escape the net investment income tax on any rental income.

Qualifying as a real estate professional, however, is rife with traps for the unwary and has been widely misunderstood since its inception. To avoid these traps, it is advisable to follow the steps detailed in this article while giving special consideration to the following:

  • Qualifying as a real estate professional, in and of itself, does not make a taxpayer's rental activities nonpassive. Rather, it merely allows the taxpayer to overcome the presumption that all rental activities are passive regardless of level of participation. For the rental activities to be nonpassive, the taxpayer must establish that he or she materially participates in each separate rental activity or, if an election is made to aggregate all rental activities, the combined activities.
  • A taxpayer engaged in multiple ventures that meet the statutory definition of a real property trade or business, such as brokerage, construction, and rental activities, is permitted, if the facts and circumstances warrant, to informally combine the ventures into one real property trade or business. This will make it easier for the taxpayer to establish that he or she materially participates in the resulting real property trade or business.
  • In determining whether a taxpayer materially participates in a real property trade or business, the taxpayer must count the hours of his or her spouse. When the taxpayer then calculates the hours from those real property trades or businesses in which he or she materially participates for purposes of the two quantitative real estate professional tests, however, the taxpayer counts only his or her own hours; the hours of the spouse may not be included.
  • A taxpayer who works full time in a non-real estate capacity faces a difficult challenge in qualifying as a real estate professional. The more-than-half test of Sec. 469(c)(7)(B) reserves the benefits of real estate professional status to those who work predominantly in a real property trade or business. Any taxpayer with significant non-real estate employment who claims real estate professional treatment is inviting scrutiny from the IRS.
  • While taxpayers are not required to maintain contemporaneous records of time they spend on real estate ventures, keeping current logs is highly recommended. Court cases have shown that taxpayers who reconstruct their hours later often overstate the time spent on rental activities, in some cases to an incredible degree. The courts are not required to accept a noncontemporaneous "ballpark guesstimate" and have shown no inclination to do so.
  • Taxpayers should pay special attention to the effect of an election to aggregate all rental activities under Regs. Sec. 1.469-9. Given the difficulty they may have meeting the material-participation standard in multiple rental activities—as well as the need to spend 500 hours in either the separate or combined rental activities to satisfy the safe harbor of the net investment income tax regulations—they should make the election in most cases. Taxpayers may wish to forgo the election, however, if they have suspended passive losses attributable to a rental activity that they intend to dispose of in the near future. Freeing up the suspended losses upon disposition will often yield a larger tax benefit to the taxpayer than currently using any rental losses.

    Footnotes

    1Added by the Revenue Reconciliation Act of 1993 (Title XIII of the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66).

    2Note that qualification as a real estate professional is not elective; however, before 2013, taxpayers with rental income and no net loss were largely indifferent as to whether they qualified under Sec. 469(c)(7).

    3Tax Reform Act of 1986, P.L. 99-514.

    4Sec. 469(d)(1).

    5Sec. 469(c)(2).

    6Sec. 469(e)(3).

    7Secs. 469(b) and (g).

    8Sec. 469(c)(1).

    9Sec. 469(c)(2).

    10Sec. 469(c)(7)(A)(i).

    11Sec. 469(c)(7)(A)(ii).

    12Sec. 469(c)(7)(A), flush language.

    13Note that a qualifying real estate professional with passive real estate rental losses may use those losses to the extent allowed by the limited exception of Sec. 469(i).

    14Sec. 469(c)(7)(C).

    15Agarwal,T.C. Summ. 2009-29.

    16Calvanico,T.C. Summ. 2015-64. Note, however, that the court concluded that the taxpayer was not a real estate professional. The hours spent at his public accounting job could not be counted toward material participation because he was not a 5% owner, as required by the statutes and regulations.

    17IRS Passive Activity Loss Audit Technique Guide, available at www.irs.gov.

    18Stanley,5:14-CV-05236 (W.D. Ark. 11/12/15).

    19Id., slip op. at 12 (quoting Sec. 469(c)(7)(B)).

    20Note, however, that as required by Sec. 469(c)(7)(D)(ii) and Regs. Sec. 1.469-9(c)(5), the employee must own at least 5% of the employer for the hours to count toward the real estate professional tests.

    21Regs. Sec. 1.469-9(d)(1).

    22The regulations require, however, that once a taxpayer determines the groupings of real property trades or businesses, the taxpayer may not redetermine them in subsequent tax years unless the original determination was clearly inappropriate or there has been a material change in the facts and circumstances that makes the original determination clearly inappropriate. See Regs. Sec. 1.469-9(d)(2).

    23Miller,T.C. Memo. 2011-219.

    24Sec. 469(h)(1).

    25Temp. Regs. Sec. 1.469-5T(a).

    26A significant participation activity is a trade or business in which the taxpayer participates for more than 100 hours during the tax year but does not materially participate in under any of the tests in Temp. Regs. Sec. 1.469-5T(a) (Temp. Regs. Sec. 1.469-5T(c)).

    27Sec. 469(c)(7)(D).

    28Calvanico, T.C. Summ. 2015-64.

    29Pungot, T.C. Memo. 2000-60.

    30Temp. Regs. Sec. 1.469-5T(f)(2)(ii).

    31Temp. Regs. Sec. 1.469-5T(e)(2). Note that the courts have held that for these purposes, a limited liability company (LLC) interest is not treated as a limited partnership interest. A taxpayer may establish material participation in an LLC interest via any of the seven tests. See Garnett,132 T.C. 368 (2009), and Thompson,87 Fed. Cl. 728 (Fed. Cl. 2009).

    32Temp. Regs. Sec. 1.469-5T(f)(3).

    33Temp. Regs. Sec. 1.469-5T(f)(4).

    34See, e.g., Hill, T.C. Memo. 2010-200, aff'd, 436 Fed. Appx. 410 (5th Cir. 2011).

    35Regs. Sec. 1.469-9(c)(4). See also Oderio, T.C. Memo. 2014-39.

    36Hassanipour,T.C. Memo. 2013-88.

    37Escalante,T.C. Summ. 2015-47.

    38Lee,T.C. Memo. 2006-193.

    39Miller,T.C. Memo. 2011-219.

    40Moss,135 T.C. 365 (2010).

    41Harnett,T.C. Memo. 2011-191, aff'd, 496 Fed. Appx. 963 (11th Cir. 2012).

    42Lewis,T.C. Summ. 2014-112.

    43Leyh, T.C. Summ. 2015-27.

    44See Perez,T.C. Memo. 2010-232.

    45Sec. 469(c)(7)(A)(ii).

    46Note, however, that a qualifying real estate professional with passive rental losses can use the $25,000 active participation exception of Sec. 469(i) to the extent allowable.

    47Regs. Sec. 1.469-9(e)(3)(ii).

    48Sec. 469(c)(7)(A), flush language; Regs. Sec. 1.469-9(g)(1).

    49Bailey,T.C. Memo. 2001-296.

    50Temp. Regs. Sec. 1.469-1T(e)(3)(ii).

    51See Kosonen,T.C. Memo. 2000-107.

    52Regs. Sec. 1.469-9(g)(3).

    53Regs. Sec. 1.469-9(g)(1).

    54Regs. Sec. 1.469-9(f)(1).

    55Regs. Sec. 1.469-9(f)(2).

    56See Jafarpour,T.C. Memo. 2012-165, and Hassanipour, T.C. Memo. 2013-88.

    57Sec. 1411.

    58Sec. 1411(c)(2)(A).

    59Regs. Sec. 1.1411-4(b).

    60Regs. Sec. 1.1411-4(g)(7)(i).

    61Regs. Sec. 1.1411-4(g)(7)(i)(B).

    62Note, however, that Regs. Sec. 1.1411-4(g)(7)(iii) provides that the inability of a real estate professional to satisfy the safe harbor does not preclude the taxpayer from establishing that rental income and gain or loss from the disposition of property, as applicable, are not included in net investment income under any other provision of Sec. 1411.

 

Contributor

Tony Nitti is a partner with WithumSmith+Brown in Aspen, Colo. Mr. Nitti also serves of the board of editorial advisers for The Tax Adviser. For more information about this column, contact thetaxadviser@aicpa.org.

 

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