The Real Estate Professional Rules
Regulations and Background
Sec. 469 of the Internal Revenue Code only allows taxpayers to utilize losses from passive activities to offset income from other passive activities. Passive activities generally include any trade or business in which the taxpayer does not materially participate and any rental activities, regardless of the level of participation. The regulations provide an exception to the presumption that all rental activities are treated as passive, and this exception can be lucrative for a taxpayer who passes the tests to qualify as a real estate professional and materially participates in rental activities. While the real estate professional rules provide an important exception for taxpayers who earn their living in the real estate world, the rules are often abused so it is not surprising that cases involving the real estate professional rules end up in tax court several times each year. Due to the tests mentioned above and described in greater detail below, taxpayers who spend part of their time in the real estate industry and part of their time in another industry will find it difficult, but not impossible, to prove that they meet the real estate professional qualification. If they do, it is vital to keep accurate and reasonable records of time spent and activities performed or courts will most likely deem the testimony to be untrustworthy and rule in the IRS’s favor.
Congress enacted Sec. 469 of the Internal Revenue Code in 1986 to put an end to abusive tax shelters by creating the concept of passive activities and limiting the deduction of losses from passive activities to income from other passive activities. For example, before Sec. 469, there was nothing stopping a lawyer making $250,000 from practicing law from buying a rental property, renting it out at fair market value, generating a large tax loss through depreciation deductions and then using that loss to offset the income from the law practice. The lawyer would be in a perfect situation because the rental home requires very little time to manage, the loss is created through noncash depreciation deductions, the investment is appreciating in value and the lawyer’s tax bill is lower.
Sec. 469 requires a taxpayer to materially participate in an activity in order for the activity to be treated as nonpassive. If the taxpayer fails to materially participate in the activity, then the activity is considered passive and any losses that it generates will only be available to offset income from other passive activities. Remaining losses are allowed to be carried forward to offset passive income in future years or they can be freed up to offset nonpassive income if the activity is disposed of in a fully taxable transaction. Furthermore, Sec. 469(c)(2) states that rental activities are per se passive, meaning that rental activities are treated as passive regardless of the taxpayer’s level of participation. After the enactment of Sec. 469, the lawyer in the example above would not be able to use the losses generated from the rental property to offset earnings from practicing law. Rather the losses would only be available to offset other sources of passive income or to be utilized when the rental property was disposed of in a fully taxable transaction.
In the years following the enactment of Sec. 469, it became apparent that a certain group of taxpayers were being treated unfairly by the regulations; specifically, those taxpayers who earn their living in real property trades or businesses. Remember, the intention of Sec. 469 is to prevent a taxpayer with a full time job in another industry from utilizing losses from a passive investment in real estate to offset ordinary business income. However, taxpayers in any industry are generally allowed to offset income from one activity with losses from another provided that they materially participate in both activities. Why should people who work in the real estate industry be treated differently? For example, assume a real estate developer spends 1,200 hours a year in his or her development company and another 1,000 hours managing 10 rental properties. The development company generates $500,000 of income and the rental properties generate $400,000 of losses, so the taxpayer’s net income from all of the real estate activities is $100,000. This taxpayer would be taxed on the $500,000, but under Sec. 469 would not be able to utilize the $400,000 of rental losses to offset this income since rental activities are per se passive under Sec. 469. To correct this unfair treatment of “real estate professionals”, Sec. 469(c)(7) was added which affords taxpayers who meet certain qualifications the opportunity to prove that they materially participate in their rental activities and they therefore should be treated as nonpassive.
The two tests that a taxpayer must meet to be considered a real estate professional are: (1) More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates (i.e., a taxpayer must spend more hours on real estate activities than non-real estate activities, to prove he or she earns their living in the real estate world); and (2) 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 (this minimum hour requirement prevents a retiree who spends 400 hours a year managing a rental property from qualifying).
Once a taxpayer passes the two tests above, he or she is considered a real estate professional. It is extremely important to note that once a taxpayer has qualified as a real estate professional, there is an additional step the taxpayer needs to take in order for his or her rental activities to be treated as nonpassive. Qualifying as a real estate professional simply allows the taxpayer to overcome the presumption that all rental activities are passive. The qualifying real estate professional now gets an opportunity that is not available to any other taxpayer, that is, to prove that he or she materially participates in the rental activities. Each rental activity that the real estate professional materially participates in will be considered nonpassive, while any rental activity that the real estate professional does not materially participate in will remain nonpassive. There is also a grouping election available to real estate professionals which allows all of the taxpayer’s rental activities to be grouped together for purposes of determining material participation in the rental activities (Regs. Sec. 1.469-9(g)). This is an all or nothing election so the real estate professional either chooses to group all rental activities together or to not group any of the rental activities.
Supporting the Claim
The real estate professional rules were enacted to provide an exception to the general passive activity rules for those who earn their living in the real estate industry. Those who meet this narrow exception should take full advantage of it in their tax planning. On the other hand, the real estate professional rules have often been misinterpreted and abused so it is not surprising that cases involving the topic often end up in tax court. Some of the basic lessons that can be learned from many of these cases are that those with full time jobs in other industries will find it very difficult to qualify as real estate professionals and documentation of time spent on real estate activities will become very important if ever called upon to support the claim. For example, assume an attorney spends over 2,000 hours per year practicing law and has some rental properties on the side. It will be difficult for the attorney to prove that in addition for the 2,000 hours spent practicing law, more than half of his or her working hours were spent managing real estate and total working hours exceeded 4,000 hours of 77 hours for all 52 weeks of the year.
There have been several cases where someone works part time in another industry and is still able to qualify as a real estate professional, but proper and reasonable documentation is always key in these cases. Although contemporaneous calendars and time logs are not required by state in this instance, the case for the taxpayer will be strengthened when this information is available and tax payers who are successful defending these types of cases tend to have testimony that is found by the court to be reasonable and credible. Taxpayers who attempt to use “ballpark guestimates” and record excessive times spent on real estate activities, such as 5-hour phone calls each day and no time carved out for meal and break times, will be unsuccessful in defending their claim as a real estate professional.
Conclusion
The real estate professional rules were enacted to provide equality for taxpayers who truly earn their living in the real estate industry by allowing these taxpayers to offset income from certain activities they materially participate in with losses from others. Taxpayers who work full time in an industry other than real estate will find it nearly impossible to qualify as a real estate professional. For taxpayers who spend part of their time in real estate and part of their time in another industry, the quality and reasonableness of documentation regarding time spent in each activity will be instrumental in supporting a claim that the taxpayer qualifies as a real estate professional.
Ask Our Experts
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Rebecca Machinga, CPA, CGMA 609-520-1188 [email protected]
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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
