Even though you may be treated as a real estate professional as defined for tax purposes, failure to make the election to treat all rental real estate activities as one activity can result in loss disallowance. This can be a costly mistake.
Under the passive activity loss (PAL) rules, losses from passive activities may only be used to offset passive activity income. Thus, such losses can’t be used to offset income from, for example, compensation, interest or dividends.
The PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. A taxpayer is treated as materially participating in an activity if he meets at least one of the seven tests. Under one of those tests, an individual will be treated as materially participating in an activity for a tax year if the individual participates in the activity for more than 500 hours during such year.
In general, any rental activity is per se a passive activity regardless of the taxpayer’s participation in the activity. However, there are exceptions to the general per se rule. Where an exception applies, a rental real estate activity is not a passive activity for the tax year if the taxpayer materially participates in the activity.
The per se rule for rental activities doesn’t apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if: (1) more than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and (2) he performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates.
If a taxpayer is a qualifying real estate professional, the PAL rules generally are applied as if each interest of the taxpayer in real estate were a separate activity. For example, the determination of whether the taxpayer materially participates is applied separately to each interest. But, a real estate professional may elect to treat all his interests in rental real estate as one activity.
The term “real property trade or business” means “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” The determination of a taxpayer’s real property trades or businesses is based on all of the relevant facts and circumstances. 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 the Code.
Only time spent in real property trades or businesses in which the taxpayer materially participates counts towards meeting the requirements of being a real estate professional.
Facts: An individual taxpayer (TP) owns two interests in rental real estate, Property 1 and Property 2, and also owns a real property development trade or business. TP does not make an election to treat all real estate activities as one. In the year at issue, TP performs more than 750 total hours of personal services on Property 1, Property 2, and the real property development trade or business, and does not provide personal services in any other trades or businesses.
IRS concludes that a failure to make the election has no effect on whether a taxpayer is real estate professional. IRS concluded that whether a taxpayer is a real estate professional within the meaning of Code Sec. 469(c)(7)(B) depends upon the rules for determining a taxpayer’s real property trades or businesses under Reg. § 1.469-9(d), and is not affected by an election under Reg. § 1.469-9(g). Instead, the election under Reg. § 1.469-9(g) is relevant only after the determination of whether the taxpayer is a real estate professional.
IRS then noted that some court opinions, while reaching the correct result, contain language which may be read to suggest that the election under Reg. § 1.469-9(g) affects the determination of whether a taxpayer is a real estate professional. It also noted that other court opinions have recognized that the election under Reg. § 1.469-9(g) is not relevant to the determination of whether a taxpayer is a real estate professional.
IRS then applies its conclusion to the facts. Looking to the facts before it for purposes of determining whether and how the PAL rules apply to the taxpayer, IRS said that the first step is to determine whether TP is a real estate professional.
TP has reasonably determined under the particular facts and circumstances that TP has a combined real property trade or business for purposes of Reg. § 1.469-9(d) that includes Property 1, Property 2, and the real property development trade or business. Because TP spends more than 500 qualifying hours on this real property trade or business, TP materially participates in this real property trade or business. Therefore, time spent on Property 1, Property 2, and the real property development trade or business may count towards meeting the qualifications of Code Sec. 469(c)(7)(B). Because TP owns an interest in rental real estate and more than one-half of the personal services performed in trades or businesses by TP during the tax year are performed in real property trades or businesses in which TP materially participates, and TP performs more than 750 hours of services during the tax year in real property trades or businesses in which TP materially participates, TP is a real estate professional within the meaning of Reg. § 1.469-9(b)(6).
Thus, Code Sec. 469(c)(2) does not apply to any rental real estate activity of TP. Instead, a rental real estate activity of TP is not a passive activity for the tax year if TP materially participates in the activity.
Next, given that TP is a real estate professional, IRS turned to whether TP materially participates in TP’s rental real estate activities to determine whether these are passive activities. In accordance with Code Sec. 469(c)(7)(A)(ii), because TP has not made an election under Reg. § 1.469-9(g), Property 1 and Property 2 are treated as separate rental real estate activities. Thus, TP must demonstrate material participation in Property 1 and Property 2 separately. In other words, TP must separately meet one of the tests in Reg. § 1.469-5T(a) for each of Property 1 and Property 2. Further, TP’s participation in the real property development trade or business is disregarded in determining whether TP materially participates in Property 1 and Property 2. If, for example, TP meets one of the tests in Reg. § 1.469-9(g) for Property 1, but not for Property 2, Property 1 will be a non-passive activity for the tax year, and Property 2 will be a passive activity for the tax year.
© 2014 Douglas Rutherford, CPA, CGMA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.
Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing