Qualifying as a real estate professional has long been a boon to taxpayers who would otherwise be limited in the losses they could deduct from rental activities. More recently, meeting the standards of a real estate professional became important even when a taxpayer generates net rental income, because only real estate professionals can exclude rental income from the new 3.8% tax on net investment income, as this prior column discusses in excruciating detail.
Despite encompassing only a few short paragraphs in Section 469, the real estate professional rules have been heavily litigated, and for some reason that defies explanation the explanation.
So what’s the issue?
Section 469 is a tangle of rules. While no one rule, standing on its own, is particularly troublesome, it always appeared that the IRS and the courts misunderstood how to fit them all together.
Under the general rule of Section 469, all rental activities are treated as passive, regardless of the individual owner’s extent of participation. As a result, rental losses can only be used to offset other sources of passive income. If the owner doesn’t have any passive income—or enough to fully offset the losses–the excess losses cannot be used currently, and instead are carried forward to future years.
An exception is carved out, however, for so-called “real estate professionals,” the idea being that someone who truly earns their living in real estate trades or businesses should be free to use rental losses without limitation.
To ensure that the benefit of the exception is preserved for those who truly deserve it, Section 469(c)(7) requires that two quantitative tests be satisfied in order for a taxpayer to qualify as a real estate professional. Here are the tests, with my plain English definition in the parenthetical:
1. More than one-half of the personal services you perform in all trades or businesses for the tax year must be performed in real property trades or businesses in which you materially participate (you must spend more hours on real estate activities than non-real estate activities, to prove that you earn your living in the real estate world), and
2. You must perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate. (This minimum-hour requirement prevents a retiree who spends 400 hours a year managing a rental property from qualifying).
Real Property Trades or Businesses
Very important to this discussion is the fact that the term “real property trades or businesses” encompasses far more than simply the rental of property; in fact, the statute lists nearly a dozen activities that constitute a real property trade or business, including development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
Thus, you do not have to be a landlord to be a real estate professional, a fact that plays a huge role in the ongoing struggle many experts have in deconstructing Section 469, and one I will address again shortly when we tie this all together.
You may have noticed that both quantitative tests hinge on your “material participation” in the real property trade or business. For this standard, we turn our attention to Reg. Section 1.469-5T, which provides seven ways in which you can establish that you materially participate in a trade or business:
1. You participate in the activity for more than 500 hours during the year,
2. Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
3. Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than the taxpayer,
4. The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours. [A significant participation activity is generally a trade or business activity (other than a rental activity) that you participate in for more than 100 hours during the year but do not materially participate in (under any of the material participation tests other than this test),]
5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,
6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
7. A generic facts and circumstances test.
Let’s put together what we have so far. In order to qualify as a real estate professional, you must:
1. Participate in a real property trade or business as defined by the statute.
2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T.
3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job.
4. The time spent participating in real property trades or businesses—but only those real property trades or business in which you materially participate—must exceed 750 hours.
Knock those four tests out, and you’re a real estate professional. By way of example:
A owns one large commercial building. He rents the building to 40 different tenants. A spends 2,000 hours managing and maintaining the building for the year, and it is A’s only job. The building kicks off a $400,000 rental loss. Is A a real estate professional permitted to use the loss in full without limitation?
Here, the determination is fairly painless. We simply run through our four tests:
1. Does A participate in a real property trade or business as defined by the statute? Sure does…rental and leasing are listed as real property trades or businesses.
2. Does A materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. Yes. A spends 2,000 hours in the activity, which is more than the 500 hours necessary to satisfy test #1.
3. Does the time spent participating in real property trades or businesses—but only those real property trades or businesses in which the A materially participates—exceed the time you spend in non-real property trades or businesses; i.e., your day job? Yes. A spends 2,000 hours on real property trades businesses in which he materially participates, and none on non-real property trades or businesses.
4. Does the time spent participating in real property trades or businesses—but only those real property trades or business in which A materially participate—exceed 750 hours? Yes. He spends 2,000 hours participating in a real property trade or business in which he materially participates, and the last time I checked, 2,000 is more than 750.
So our guy A can deduct his rental loss in full, right?
Not so fast. What many people don’t realize—though this is not the part the courts have consistently gotten wrong—is that satisfying the two quantitative tests and qualifying as a real estate professional does not guarantee that your rental activities are non-passive. It simply means that your rental activity is not passive regardless of your level of participation. Stated in another manner, qualifying as a real estate professional is simply the first step in the process; it merely buys you the opportunity to prove that you materially participate in your rental activities, and can thus treat them as non-passive.
Let’s go back to our example. A clearly qualifies as a real estate professional. But that is merely the first step. Next, A has to establish that he materially participates in his rental activity. For A, this easy; he spent 2,000 hour on his one rental activity, so he materially participates by any measure of the -5T regulations.
But what if we switch the facts a bit? Assume A spent 2,000 hours in the real estate trade or business of construction, and owned one rental property on which he spent only 50 hours collecting rent checks throughout the year, and he paid a full-time property manager to do the rest. Assume further that the rental produces a $100,000 loss. How does that change the analysis?
In this case, A would still qualify as a real estate professional, by virtue of his 2,000 hours spent materially participating in his construction business.
Simply qualifying as a real estate professional is not enough to convert A’s rental loss to non-passive, however. In order for that to be accomplished, A must now establish that he materially participates in the rental activity, which he will fail to do by virtue of the fact that he spent only 50 hours on the activity, and other people spent more time than him on the activity. As a result, even though A is a real estate professional, his rental loss remains passive.
As you can see, these rules are (fairly) straightforward when you have only one rental property. Where the IRS and courts have gone wrong, however, is in measuring whether a taxpayer with multiple rental activities qualifies as a real estate professional.