Gains & Losses
The interaction of Secs. 469 and 1411 present special challenges for real estate professionals and their advisers.
Real Estate Professional Status
Sec. 469 imposes restrictions on the allowance of passive activity losses and credits. Under Sec. 469(c)(2), passive activities include any rental real estate activity except as provided in Sec. 469(c)(7).
Sec. 469(c)(7) has special rules for individuals in real property businesses. If a taxpayer meets the Sec. 469(c)(7)(B) requirements, the taxpayer will be considered a real estate professional, and that person's rental real estate activities will no longer be per se passive.
For a taxpayer to qualify under Sec. 469(c)(7)(B), more than one-half of the personal services he or she performs in trades or businesses during the tax year must be performed in real property trades or businesses in which he or she materially participates, and the taxpayer must perform more than 750 hours of services in real property trades or businesses in which he or she materially participates.
Real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
For individual income tax purposes exclusive of the 3.8% net investment income tax imposed by Sec. 1411, establishing real estate professional status does not automatically permit an individual to treat his or her rental real estate activities as nonpassive. A taxpayer must meet one of seven material participation requirements of Temp. Regs. Sec. 1.469-5T for each of his or her rental real estate activity to qualify as nonpassive:
- The individual participates in the activity for more than 500 hours during the year;
- The individual's participation in the activity for the tax year constitutes substantially all of the participation in that activity of all individuals for that year;
- The individual participates in the activity for more than 100 hours during the tax year, and his or her participation in the activity for the tax year is not less than any other individual's participation in the activity for that year;
- 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;
- The individual materially participated in the activity for any five tax years during the 10 tax years that immediately precede the tax year;
- The activity is a personal service activity, and the individual materially participated in the activity for any three tax years preceding the tax year; or
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
Sec. 1411 modified the material participation requirements for real estate professionals to be able to exclude their rental real estate activity from the net investment income tax. Real estate professionals may exclude their rental real estate activity under the safe harbor in Regs. Sec. 1.1411-4(g)(7)(i). To qualify for the safe harbor, a real estate professional must participate in a rental real estate activity for more than 500 hours during the year or participate in the rental real estate activities for more than 500 hours in any five tax years during the 10 tax years that immediately precede the tax year. Thus, the Sec. 1411 safe harbor adopts two of the seven tests from the Sec. 469 material participation regulations.
If a real estate professional fails either 500-hour safe-harbor requirement, he or she is not completely prohibited from excluding his or her rental real estate activities from net investment income. Regs. Sec. 1.1411-4(g)(7)(iii) permits taxpayers who do not meet the safe harbors to establish that they are excluded from the tax under another provision of Sec. 1411. For example, a taxpayer who does not meet the 500-hour requirement may still be exempt from the tax as long as he or she can establish that the rental activity rises to the level of a trade or business.
In the preamble to T.D. 9644, Treasury provided the following example to support the need for a modification to the material participation test as it applies to the Sec. 1411 tax:
[A] real estate broker that satisfies the section 469(c)(7) real estate professional requirements by reason of hours devoted to brokerage could classify his or her real property rental activity as nonpassive by satisfying § 1.469-5T(a)(2). Under this test, the taxpayer needs to establish only that the taxpayer's participation in the activity was substantially all of the activity (taking into account all other persons involved in the activity) to establish material participation.
The limitation of the material participation requirement as it applies to Sec. 1411 was intended to prevent individuals in real property trades or businesses that own ancillary rental real estate activities from qualifying for the exclusion under the safe harbor. The ability to exclude the activity from net investment income without meeting the safe harbor under Regs. Sec. 1.1411-4(g)(7)(iii) leaves a door open for taxpayers to avoid the material participation tests, which will undoubtedly lead to future litigation.
To meet the material participation requirements of Temp. Regs. Sec. 1.469-5T, the safe harbor of Regs. Sec. 1.1411-4(g)(7)(i), or Regs. Sec. 1.1411-4(g)(7)(iii), a taxpayer may elect to treat all rental real estate as a single rental activity under Regs. Sec. 1.469-9(g).
A taxpayer may treat two 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 type of trades or businesses, the extent of common control, the extent of common ownership, geographical location, and interdependence between or among the activities.
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 under Regs. Sec. 1.469-9(g), 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. Additionally, a taxpayer cannot group real property rental and personal property rentals unless there is a connection between the two rental activities.
Before Sec. 1411 was enacted, once a taxpayer grouped activities, he or she was not permitted to regroup the activities unless there had been a material change in the facts and circumstances. However, the final Sec. 1411 regulations made several changes to the Sec. 469 grouping rules to give individuals, trusts, and estates a one-time opportunity to regroup their activities. Under Regs. Sec. 1.469-11(b)(3)(iv), a taxpayer may regroup his or her activities without requesting IRS permission during the first tax year beginning after Dec. 31, 2013, in which the taxpayer is subject to the net investment income tax or for any tax year that began in 2013 in which the taxpayer meets the eligibility criteria. The eligibility criteria are that the taxpayer (1) meets the applicable income threshold under Sec. 1411 and (2) has net investment income.
A taxpayer is permitted to file an amended tax return to regroup his or her activities only if he or she was not previously subject to the Sec. 1411 tax on his or her original tax return (or previously amended return) and if the changes being reported on the amended tax return would cause the taxpayer to be subject to the Sec. 1411 tax. Conversely, if a taxpayer regroups his or her activities and files a tax return that has a Sec. 1411 liability and it is later determined that the taxpayer did not meet the eligibility criteria, the regrouping for that year will have no effect for that year and all future years.
Former Passive Activities
Grouping or regrouping activities may provide taxpayers with the opportunity to use suspended passive losses and credits. Under Regs. Sec. 1.469-9(e)(2), for any tax year in which a qualifying taxpayer materially participates in a rental real estate activity, that activity will be treated as a former passive activity if disallowed deductions or credits are allocated to the activity. The result of the regrouping may allow the suspended passive losses of one of the former passive activities to offset the income of another entity within the same group. Using suspended passive losses by way of grouping or regrouping may provide taxpayers with a greater tax benefit for their suspended passive losses compared with prior years because of increased income tax rates and the imposition of the Sec. 1411 tax.
While the qualifications of being a real estate professional, meeting the material participation requirement, and grouping activities are nothing new, the imposition of the Sec. 1411 tax highlighted the importance of these rules for the taxation of individuals in real property trades or businesses. The onerous task of proving real estate professional status and demonstrating that a taxpayer's activities give rise to a trade or business will always be the taxpayer's responsibility. Tax professionals with clients who are real estate professionals need to familiarize themselves with the modifications to the regulations under Sec. 469 and the addition of Sec. 1411 and its regulations for tax planning opportunities and vulnerabilities.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP