The IRS Figures Out The Real Estate Professional Rules – Part 2

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Two Grouping Elections

When a you have one activity under the meaning of Section 469—whether it be a rental property or a partnership or S corporation interest– materially participating in the activity requires 500 hours of your time (assuming you don’t want to have to consider the hours of any other person participating in the activity), an achievable standard by even the laziest among us.

But what if you have ten partnership interests? Or seven rental properties? Are you reasonably expected to spend 500 hours in each activity? The answer is no, and the regulations under Section 469 offer two alternatives for determining material participation when you have multiple activities.

Under Reg. Section 1.469-4, you can elect to group activities together for purposes of measuring material participation; make the election, and you are permitted to aggregate the hours spent in the grouped activities.

The regulations allow you to group activities however you see fit, provided that 1) the grouped activities represent an “appropriate economic unit,” and 2) you generally cannot group rental activities with non-rental activities. As a result, the -4 regulations are often referred to as the “slice and dice” elections, because you can carve up your activities into multiple groupings for purposes of measuring material participation.

Of course, grouping together rental activities under the -4 regulations is largely a meaningless gesture, because unless you qualify as a real estate professional, it doesn’t matter whether you materially participate, because all rental activities are treated as passive under Section 469.

To assist a real estate professional with multiple activities to overcome the treatment of rental activities as passive, the regulations offer another elective regime. Remember, qualifying as a real estate professional does not make your rental properties non-passive; rather, it gives you the opportunity to establish that you materially participate in your rental activities, in which case they will become non-passive.

Reg. Section 1.469-9(g) provides that for purposes of establishing this material participation, a real estate professional may elect to treat all interests in rental activities as one activity. In contrast to the -4 election, the -9 election is an “all or nothing” election; you either group all of the rental activities, or you group none of them. If you make the election, you measure your material participation in your rental activities by summing the hours of time spent on all rental activities. Fail to make the election, and you must establish that you materially participate in each separate activity.

So, if we layer the -9 regulations on top of the steps we established earlier for determining if you qualify as a real estate professional and can use rental losses without limitation, it would look like this. 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. For these purposes, you can use the grouping elections made under the -4 “slice and dice” regulations to determine whether you materially participate in those real property trades or businesses.

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 as determined under #2 above—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 as determined under #2 above —must exceed 750 hours.

Congrats! Pass those four tests, and you’re a real estate professional. But don’t forget the all-important last step!

5. You must materially participate in your rental properties. This will be the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made.

Tax Court Misinterpretation

The IRS and courts have frequently made a mess of the steps described above. The problem has been the undue amount of importance placed on the “all or nothing” election of -9 to aggregate all rental activities of the taxpayer for purposes of measuring material participation. In several decisions, the -9 election has been elevated above its proper place in the real estate professional determination; the IRS has used the -9 election to determine if a taxpayer qualifies as a real estate professional, despite the fact that, as indicated above and quite plainly in the regulations, the -9 election applies only to a taxpayer who has already qualified as a real estate professional for the sole purpose of determining whether the taxpayer materially participates in his rental activities.

In Jahina v. Commissioner, T.C. Summary Opinion 2002-150, a taxpayer was denied real estate professional status because she failed to make the election under -9 to aggregate all of her rental activities. As a result, the court concluded:

As a consequence of the failure to elect, Mrs. Jahina must qualify as a real estate professional with respect to each property separately in order to avoid a determination that the rental activities were per se passive under Section 469. Thus, to hold in petitioners’ favor, the Court must find 1) That more than one-half of Mrs. Jahina’s personal services during the tax year were performed in each rental property activity and 2) that Mrs. Jahina performed more than 750 hours of services during the tax year on each of the claimed properties (emphasis added).

The Tax Court employed a similar incorrect approach in Jafapour v. Commissioner, T.C. Memo 2012-165 and Hassanipour v. Commissioner, T.C. Memo 2013-88.

If you’ve been following along, it becomes apparent that the court is asking the taxpayer who fails to file a -9 grouping election to satisfy two statistical impossibilities: 1) to spend more than half his time working on each rental activity, and 2) spend more than 750 hours on each rental activity (while technically not an impossibility, it becomes a realistic improbability as the number of rental activities increase.)

This is not what the Code and regulations require, and placing this burden on a taxpayer can result in incorrect conclusions. To illustrate:

A owns five commercial rental properties. He spends 600 hours on property A, 300 on property B, 300 on property C, 250 on property D, and 300 on property E. A performs no other services throughout the year. Assume that under Reg. Section 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in properties B, C, D, or E (i.e., he satisfied one of the other six tests for those four properties). Because he materially participates in each separate activity, A did not elect to group the activities together under Reg. Section 1.469-9. Assume each property produces a loss for the year.

Using the Tax Court’s approach, because A failed to make the election to group the activities under -9, A must measure his qualification as a real estate professional on a property by property basis. Thus, because A did not spend more than 750 hours in any one property, he will fail to qualify as a real estate professional, and all of his losses will be treated as passive.

Under the proper approach, however, we get a very different result. Let’s go back to our steps; A must:

1. Participate in a real property trade or business as defined by the statute. As a lessor of property, A meets this standard.

2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. A materially participates in each of his rental activities;

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. Because A materially participates in each separate rental activity, we can count the hours spent in each activity towards the total. He spent 1,750 hours on his real property trade or business (rental activities) and none on non-real property trades or businesses. As a result, this test is satisfied.

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. Once again, because A materially participated in each rental activity, we can use all 1,750 hours for the purposes of this test. Thus, A has spent more than the requisite 750 hours. Because he has passed both tests, A qualifies as a real estate professional. Notice, we have not yet addressed the implications of making the “all or nothing” grouping election of -9.

5. You must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made. Now that A has established himself as a real estate professional—and only now—we look to whether an election to group his rental activities was made under -9. This is because the election is only relevant when a taxpayer who has qualified as a real estate professional under the two quantitative tests of Section 469(c)(7), as A has, must take the next step of establishing that he materially participates in his rental activities. Despite the fact that A has not made the election, because he materially participates in each separate activity, each activity is treated as non-passive.

By limiting the application of the -9 grouping election to after the real estate professional tests are satisfied, we get the correct result that A’s rental losses are non-passive. The results would be equally as glaring if A were a real estate professional by virtue of a non-lessor activity.

A works in construction for 2,000 hours per year. He also owns three rental properties. He spends 200 hours on property A, 200 on property B, and 200 hours on property C. Assume that under Reg. Section 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in any one activity (i.e., he satisfied one of the other six tests for those four properties). Because he materially participates in each separate activity, A did not elect to group the activities together under Reg. Section 1.469-9. Assume each property produces a loss for the year.

Under the court’s approach, because A did not make the grouping election under -9, A would have to satisfy the “more than half” and “750 hour” test for each property, which he clearly cannot do. Thus, he would fail to qualify as a real estate professional.

Under the correct approach, however, A must:

1. Participate in a real property trade or business as defined by the statute. As a builder of real estate, A meets this standard.

2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. A spends 2,000 hours in his construction business, and thus materially participates.

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. Because A materially participates in his construction business and each of his three rental properties, we can count the hours spent in each activity towards the total. He spent 2,600 hours on his real property trade or business (construction and rental activities) and none on non-real property trades or businesses. As a result, this test is satisfied.

4. The time spent participating in real estate trades or businesses—but only those real estate trades or business in which you materially participate—must exceed 750 hours. Once again, because A materially participated in his construction activity and each rental activity, we can use all 2,600 hours for the purposes of this test. Thus, A has spent more than the requisite 750 hours. Because he has passed both tests, A qualifies as a real estate professional. Notice, we have not yet addressed the implications of making the “all or nothing” grouping election of -9.

5. You must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made. Despite the fact that A has not made the election to group his rental activities, because he materially participates in each separate activity, each activity is treated as non-passive.

The IRS Comes Around

It appears that our long national nightmare of smart people misinterpreting the real estate professional rules has mercifully come to an end. In CCA 201427016, the IRS acknowledged the shortcomings of previous court decisions, and clarified that the “all or nothing” grouping election of Reg. Section 1.469-9 applies only after a taxpayer qualifies as a real estate professional.

In the ruling, the facts were nearly identical to the example we just addressed. The taxpayer owned two rental properties and a development business. The taxpayer spent more than 750 hours—in total—on the three activities, and did not elect to group the two rental activities together. The ruling then succinctly addressed the issue that has been the subject of 4,000 words in this column: If a taxpayer fails to elect to group all rental activities together under Reg. Section 1.469-9, do the two quantitative tests of Section 469(c)(7) apply separately to each rental activity?

The IRS concluded that they do not, once and for all clarifying that the determination of whether a taxpayer satisfies the real estate professional rules is unaffected by the -9 grouping election; rather, the grouping election is relevant only after the taxpayer qualifies as a real estate professional to determine if the taxpayer materially participates in his rental activities.

Applying this rationale to the facts in in the ruling, the IRS concluded that:

1. The taxpayer was involved in a real property trade or business comprised of a development business and two rental activities;

2. The taxpayer materially participated in the real property trade or business by virtue of having spent more than 500 hours in the activity;

3. The taxpayer satisfied the “more than half” test;

4. The taxpayer satisfied the “more than 750 hours” test and thus qualified as a real estate professional.

5. At this point, the only thing standing between the taxpayer and non-passive rental losses was the determination of whether he materially participates in the activities. Because no grouping election was made under -9, material participation had to be measured on a property by property basis. One property satisfied the material participation test; one did not.

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