Relief for Late Election to Treat All Real Estate Rental Interests as One Activity

Editor: Alan Wong, CPA

Gains & Losses

The IRS has issued guidance on how certain taxpayers can make a late election to treat all interests in rental real estate as a single rental real estate activity (Rev. Proc. 2011-34).

Background

Sec. 469 imposes restrictions on the allowance of passive activity losses and credits. Under Sec. 469(c)(2) passive activity includes any rental real estate activity except as provided in Sec. 469(c)(7).

Sec. 469(c)(7) provides special rules for taxpayers in real property businesses. If a taxpayer meets the requirements of Sec. 469(c)(7)(B), the taxpayer will qualify as a real estate professional, and the rental real estate activity will no longer be presumptively passive.

Under Sec. 469(c)(7)(B), for a taxpayer to qualify as a real estate professional, more than one-half of the personal services that the taxpayer performs in trades or businesses (individual, estate, or trust) during the tax year must be in real property trades or businesses in which the taxpayer materially participates, and the taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

In the case of a closely held C corporation, the requirements of the above paragraph are met for any tax year if more than 50% of the gross receipts of such corporation for the tax year are derived from real property trades or business in which the corporation materially participates. Personal services performed as an employee are not treated as performed in real property trades or businesses unless such employee is a 5% owner. “Real property trade or business” is widely defined and includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Election

Sec. 469(c)(7)(A) provides that each of a taxpayer’s interests in rental real estate is treated as a separate activity for determining whether the taxpayer materially participates in each rental real estate activity. However, Regs. Sec. 1.469-9(g) permits a taxpayer to make an election to treat all of the taxpayer’s interest in rental real estate as a single rental real estate activity. To make the election, a qualifying taxpayer needs to file a statement with the taxpayer’s original income tax return for the tax year. The statement must contain a declaration that the taxpayer is a qualifying taxpayer for the tax year and is making the election pursuant to Sec. 469(c)(7)(A).

The election is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying rental real estate professional, even if there are intervening years in which the taxpayer is not a qualifying taxpayer. In years in which the taxpayer is not a qualifying taxpayer, the rental real estate activities will be treated as passive activities.

The taxpayer may revoke the election if there is a material change in the taxpayer’s facts and circumstances. To revoke the election, the taxpayer needs to file a statement with the taxpayer’s original income tax return for the tax year. The 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.

Grouping Activities

Regs. Sec. 1.469-4 sets forth the rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of Sec. 469.

A taxpayer may treat one or more trade or business activities or rental activities as a single activity if the activities constitute an appropriate economic unit. In determining appropriate economic units, factors to be considered are similarities and differences in types of trades or businesses, the extent of common control, the extent of common ownership, geographical location, and interdependence between or among the activities.

A taxpayer may not group a rental activity with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit and are insubstantial in relation to each other. For example, a taxpayer may not group a rental activity with a trade or business activity unless the rental activity is de minimis in relation to the trade or business activity. Conversely, a taxpayer may not group a trade or business activity with a rental activity unless the trade or business activity is de minimis in relation to the rental activity.

If a taxpayer qualifies as a real estate professional and makes the election to treat all his or her interests in rental real estate as a single rental real estate activity, the taxpayer may not group a rental real estate activity with any other activity, even if the other activity is in a real property trade or business. For example, if a qualifying taxpayer develops real property, constructs buildings, and owns an interest in rental real estate, the taxpayer may not group the interest in rental real estate with his or her development activity or construction activity if he or she makes the election.

Once a taxpayer has grouped activities, he or she may not regroup those activities in subsequent years. However, if a taxpayer determines that the original groupings were inappropriate or there has been a material change in the facts and circumstances, the taxpayer must regroup the activities. A taxpayer cannot group real property rental and personal property rentals unless there is a connection between the two rental activities.

Disposition of an Activity

If there is a disposition of substantially all of an activity, a taxpayer can treat the disposed activity as a separate activity if he or she can establish with reasonable certainty the carryover of disallowed deductions and credits related to that activity and can determine the amount of gross income, deductions, and credits allocable to that part of the activity for the tax year.

Example 1: Z, a materially participating real estate professional, has two rental properties, a warehouse and a residential apartment, which Z has elected to treat as a single rental real estate activity. If Z disposes of the warehouse (which is substantially all of her activity), she can treat the warehouse as a separate activity and will free up all suspended passive activity losses and credits for the warehouse.

Example 2: The facts are the same as in Example 1, except Z owns 15 residential apartments and does not own a warehouse. If Z disposes of 3 of the 15 apartments, there is not a substantial disposition of the activity. As a result, Z will not free up any of the suspended passive activity losses of the three apartments that were disposed of because she cannot treat the apartments as separate activities.

Is the Election Beneficial?

A taxpayer may or may not want to make an election to treat all interests in rental real estate as a single rental real estate activity. In Example 1, where a materially participating real estate professional held two rental properties, if Z spends 760 hours during the year on the warehouse and only 75 hours on the apartment, she will qualify as a materially participating real estate professional if she owns only the warehouse but will not qualify if she owns only the residential apartment. By making the election, the income and loss from the warehouse and residential apartment will be nonpassive. If Z does not make the election, only the income and loss from the warehouse will be nonpassive.

In Example 2, where the taxpayer owns 15 residential apartments and disposes of 3 of them, Z spends 60 hours during the year on each apartment (900 hours total). If she does not make an election to treat all her interests in rental real estate as a single rental real estate activity, all the activities will be passive, and all suspended losses of the disposed apartments will be allowed. If Z makes the election to treat all her interest in rental real estate as a single rental real estate activity, all the income and loss will be nonpassive, but all suspended losses of the disposed activities will remain suspended because there will not be a substantial disposition of the real estate activity.

Eligibility for Relief of Late Election

On May 31, 2011, the IRS issued Rev. Proc. 2011-34, which provides special procedures for relief for late Regs. Sec. 1.469-9(g) elections. The revenue procedure gives taxpayers the ability to obtain relief for a late election without the burden of obtaining a private letter ruling. Under this revenue procedure, the user fees associated with private letter rulings do not apply to those seeking relief for a late election.

A taxpayer is eligible for an extension of time to file a Regs. Sec. 1.469-9(g) election if the taxpayer represents in a statement that he or she meets all the following requirements:

• The taxpayer failed to make an election under Regs. Sec. 1.469-9(g) solely because he or she failed to timely meet the requirements in Regs. Sec. 1.469-9(g);
• The taxpayer filed consistently with having made an election under Regs. Sec. 1.469-9(g) on any return that would have been affected if he or she had timely made the election;
• The taxpayer timely filed each return that would have been affected by the election if it had been timely made; and
• The taxpayer has reasonable cause for his or her failure to meet the requirements in Regs. Sec. 1.469-9(g).

The taxpayer must attach the statement required by Regs. Sec. 1.469-9(g)(3) to an amended return for the most recent tax year and mail the amended return to the IRS Service Center where he or she will file the current-year tax return. The statement must contain the declaration required by Regs. Sec. 1.469-9(g)(3), an explanation of the reason for the failure to file a timely election, and a declaration of the four requirements previously stated. The statement must identify the tax year for which the taxpayer seeks to make the late election. Finally, the statement must state at the top of the document “Filed Pursuant to Rev. Proc. 2011-34.”

The taxpayer must sign the declaration and representations under penalties of perjury.

Conclusion

The relief provided to taxpayers under Rev. Proc. 2011-34 to make a late Regs. Sec. 1.469-9(g) election to treat all a taxpayer’s interest in rental real estate as a single rental real estate activity is extremely valuable to a materially participating real estate professional. If a taxpayer fails to make the election and comes under audit for a prior year or years in which rental activities had been treated as nonpassive, without a valid election the taxpayer’s nonpassive losses could be converted to passive losses and disallowed. The rules and regulations relating to real estate professionals and their ability to treat their real estate activities as nonpassive is a tool that can benefit taxpayers, but it is the responsibility of the real estate professionals to abide by the countless rules spelled out in the Code and other authority.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.