Real Estate
The IRS Office of Chief Counsel in Chief Counsel Advice (CCA) 201427016 on July 3 advised on the interaction of the rental real estate grouping election under Regs. Sec. 1.469-9(g) and the real estate professional exception to the passive activity loss rules under Regs. Sec. 1.469-9(b)(6). The advice may not be cited as precedent, but it provides insight into how the IRS might view this topi c.
Breaking Down the Basics
Four relevant Code and regulations sections must be considered, and they should not be confused with one another:
- Temp. Regs. Sec. 1.469-5T material participation test (to establish that a taxpayer's interest in a trade or business is not a passive activity);
- Regs. Sec. 1.469-9 and Sec. 469(c)(7) test for determining status as a "qualifying taxpayer" (often referred to as a "real estate professional");
- Regs. Sec. 1.469-9(g) grouping election allowing a qualifying taxpayer to treat all rental real estate activities as a single activity; and
- Sec. 469 passive activity loss limitation rules generally.
Also note that some of these Code and regulations sections refer to rental activities, while others refer more specifically to rental real estate activities. It is also important to distinguish between the activity groupings used in applying the material participation test and the real property trades and businesses considered in determining whether a taxpayer qualifies as a real estate professional.
Real Estate Professional and Material Participation Tests
A key element of confusion, as highlighted by this CCA, is the separate application of the real estate professional test in Sec. 469(c)(7)(B) and Regs. Sec. 1.469-9(c), and the material participation test for activities of Temp. Regs. Sec. 1.469-5T. The tests are similar in their use of qualifying hours of service and in their application, but they have distinct purposes. Either the material participation tests under Temp. Regs. Sec. 1.469-5T will apply, or both tests will apply—first the real estate professional test under Sec. 469(c)(7)(B) and Regs. Sec. 1.469-9(c) and then the Temp. Regs. Sec. 1.469-5T material participation test.
This item touches on a third layer of complexity, the grouping election, later. For now, it should be noted that the election under Regs. Sec. 1.469-9(g) is available only to a qualifying real estate professional. Therefore, this election cannot affect the outcome of the qualifying real estate professional test for a taxpayer. In the CCA, the taxpayer had not made a Regs. Sec. 1.469-9(g) grouping election. The OCC concluded that this fact did not have an effect on whether the taxpayer qualified as a real estate professional under Sec. 469(c)(7) and Regs. Secs. 1.469-9(b) and (c).
Consequences and Mechanics of the Interacting Code Sections
If the taxpayer is not active in any qualifying real property trades or businesses, the taxpayer cannot be a real estate professional. Thus, the Temp. Regs. Sec. 1.469-5T material participation tests are applied only to the taxpayer's nonrental activities to determine if they are passive activities, and all rental activities are treated as passive activities, regardless of the taxpayer's level of participation. In the case of a taxpayer who is active in one or more qualifying real property trades or businesses (as defined in Sec. 469(c)(7)(C)), to determine whether the taxpayer's rental activities are passive activities, first the real estate professional test is applied to the taxpayer, and then the material participation test of Temp. Regs. Sec. 1.469-5T is applied to the rental activities. (Real property trades or businesses include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.)
It is important to note that simply qualifying as a real estate professional does not preclude a taxpayer's rental activity from being treated as a passive activity. As the CCA points out, qualifying as a real estate professional merely provides the opportunity to apply the material participation tests to the qualifying taxpayer's rental real estate activities to determine if they are passive activities. The corollary is that if a taxpayer does not qualify as a real estate professional, all of the taxpayer's rental activities are considered passive, regardless of the taxpayer's level of involvement, because Sec. 469(c)(2) states that the term "passive activity" includes any rental activity. Note that this Code section does not distinguish between rental real estate activities and other rental activities; it states that all rental activities are passive by default. The only way around this is Sec. 469(c)(7)(B).
Qualifying as a Real Estate Professional
In determining whether the taxpayer qualifies as a real estate professional, the grouping election under Regs. Sec. 1.469-9(g) will not affect whether the taxpayer fulfills the requirements of Sec. 469(c)(7)(B) (performs more than 750 hours of personal services during the tax year in real property trades or businesses in which he or she materially participates, and such services are more than half of the personal services the taxpayer performs in all trades or businesses in which he or she materially participates).
A taxpayer may use any reasonable method of applying the facts and circumstances in determining the real property trades or businesses in which the taxpayer provides personal services. Under a consistency requirement, once a taxpayer determines the real property trades or businesses in which personal services are provided, the taxpayer may not redetermine those real property trades or businesses in subsequent tax years, barring a material change in facts and circumstances that makes the grouping clearly inappropriate, or if it is determined that the original grouping was clearly inappropriate (Regs. Sec. 1.469-9(d)).
There is a slight crossover here, as Regs. Sec. 1.469-9(b)(5) provides that "material participation" for purposes of qualifying as a real estate professional has the same meaning as under Temp. Regs. Sec. 1.469-5T. It is important to keep in mind, however, that the former provision deals with real property trades or businesses as determined pursuant to Regs. Sec. 1.469-9(d), and that the grouping of the real property trades and businesses for this purpose may differ from that of the taxpayer's activity groupings, which might be used in later applying the material participation tests under Temp. Regs. Sec. 1.469-5T.
If the taxpayer meets these requirements, the next hurdle is to apply the material participation tests to the rental real estate activities. This is where the grouping election of Regs. Sec. 1.469-9(g) can come into play.
Material Participation Test and the Grouping Election
As noted above, a rental real estate activity of a taxpayer who is a real estate professional is not a passive activity for the tax year if the taxpayer materially participates in the activity. As with any other type of activity, a taxpayer materially participates in a rental real estate activity if the taxpayer satisfies one of the seven tests in Temp. Regs. Sec. 1.469-5T.
Under Sec. 469(c)(7)(A), each interest of the taxpayer in rental real estate is treated as a separate activity for purposes of determining whether the taxpayer materially participates in the rental real estate activity, unless the taxpayer, in a year in which the taxpayer qualifies as a real estate professional, makes an election under Regs. Sec. 1.469-9(g) (the grouping election) to treat all interests in rental real estate as a single rental real estate activity for the material participation tests of Temp. Regs. Sec. 1.469-5T. The grouping election applies to the current tax year and all future tax years, even if there are intervening tax years in which the taxpayer is not a real estate professional.
The failure to make the election in one year does not preclude the taxpayer from making the election in a subsequent year. In years in which the taxpayer is not a real estate professional, the election will have no effect, and the taxpayer must group the activities according to the general grouping rules in Regs. Sec. 1.469-4. Once the taxpayer makes the election, it may be revoked only in the event of a material change in circumstances.
Conclusion
A failure to make the election to treat all of the rental real estate activities of a taxpayer as one activity could lead to an unfavorable result where the taxpayer qualifies as a real estate professional but does not pass the material participation tests for each activity. In this situation, the rental real estate activities that do not separately meet one of the material participation tests will be treated as passive activities, subject to the passive activity loss rules, even though the taxpayer qualifies as a real estate professional.
A missed grouping election for rental real estate activities can be costly. However, making the election will not always yield favorable results for a taxpayer, and there are limitations on the revocation of the election. Therefore, each taxpayer's circumstances should be considered carefully before the election is made.
EditorNotes
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-422-7244 or mcook@singerlewak.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.
