Unlock Tax Savings with Real Estate Professional Status

Are You a “Real Estate Professional?”

Passive Activity Loss (PAL) Rules

Most taxpayers who are considered real estate professionals are those who own properties and rent them out throughout the year. Under the Internal Revenue Code (IRC), rental activities, and any related income received, are presumed to be passive. IRC Sec. 469 sets out the PAL rules. Those rules limit a taxpayer’s ability to offset net losses from passive activities (PAs) against non-passive sources of income, such as wages or interest and dividends. Losses related to PAs may be deducted only to the extent of a taxpayer's PA income. Any remainder PALs is carried forward and only offset when (1) the PAs generate a gain or (2) upon the disposal of the real estate property. Fortunately, a real estate professional (REP) who “materially participates” in a real property trade or business is not subject to these PAL limitation rules and may use rental losses to offset other sources of nonpassive ordinary income.

Net Investment Income Tax

The Net Investment Income Tax (NIIT), applies to any income that is derived from “investment” income, such as interest, dividends, royalties, or rentals. A REP may not be subject to the NIIT provided that:

• the taxpayer meets the definition of a REP (see below),

• rental income is derived in the ordinary course of a trade or business, and

• the rental activity is not considered a PA under IRC. Sec. 469.

If the REP participates for more than 500 hours in the current taxable year, a safe harbor rule under Treas. Reg. Sec. 1.1411-4 deems rental income associated with the activity to be derived in the ordinary course of business. This rule also applies if the REP participated for more than 500 hours a year for any five of the previous ten years, whether consecutive or not.

Real Estate Professional (REP) Test

Taxpayers must satisfy three tests to be deemed a REP. To qualify as a REP, a taxpayer must:

•  Perform more than 50% of services in real property trades or businesses (“50% test”),

•  Perform more than 750 hours of service in real property trades or businesses (“750 hours test”), and

• Materially participate in each rental activity (“material participation test”).

Real Property Trade or Business Defined

A real property trade or business is broadly defined under IRC Sec. 469(c)(7) to include real property development, re-development, construction, reconstruction, acquisition, rental, operation, management, leasing, or brokerage trade or business. [Caution: According to Chief

Counsel Advice 201504010, “real property trade or business” includes real estate brokers, but not mortgage brokers of financial instruments used to purchase real estate. Similarly, the Tax Court has held that “mere financing of or investing in real property” was not a real property trade or business.]

The 50% and 750 Hours Tests

For married taxpayers, the 50% test and 750 hours test is able to be met by one spouse alone. All real property trade or business activity is included under the 750 hours test, regardless of whether an election has been made to aggregate the properties into one real property trade or business, as discussed below.

Material Participation Test

Material participation is determined separately for each rental property. For taxpayers with several rental properties, while it may be difficult to meet the material participation test on a separate property basis, the IRS permits taxpayers to make an election to treat all interests as a single rental real estate activity. The aggregation election is made by attaching a statement to a timely filed tax return. As a general rule, this election is binding until revoked and covers future years. Rev. Proc. 2011-34 provides relief for a late aggregation election if reasonable cause is established.

What is Considered “Material Participation”?

Treas. Reg. Sec. 1.469-5T specifies that a taxpayer must satisfy at least one of the following to be considered a material participant:

•  Work more than 500 hours in the activity (for purposes of material participation, IRC Sec. 469 specifies that participation of both spouses is counted; however, participation by children or employees is not counted);

• Do substantially all of the work in the activity;

• Work more than 100 hours in the activity and no one else works more than the taxpayer (including non-owners or employees);

• Total time in all significant participation activities (SPA), defined under Treas. Reg. Sec. 1.469-5T(c), exceeds 500 hours;

•  Have materially participated in the activity in any five of the prior ten years;

•  Materially participate in a personal service activity, defined under Treas. Reg. Sec. 1.469-5T(d), for any three prior years; or

• Participate in the activity on a regular, continuous, and substantial basis during such year based on the facts and circumstances.

The material participation rules require an analysis of all surrounding facts and circumstances. Generally, work performed as an investor is not treated as participation. However, when an individual is directly involved in the day-to-day management or operations of the real estate activity, the Tax Court has found that an otherwise investor-activity may count toward material participation.

Contemporaneous Documentation

To substantiate the time spent on real estate activities, the IRS requires detailed records to support the hours worked in real estate in relation to those worked in other businesses. The extent of an individual’s participation in an activity may be established by any “reasonable means.” Treas. Reg. Sec. 1.469-5T(f) states that “reasonable means” may include, but are not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing those services over that period, appointment book details, calendars, or narrative summaries. Non-contemporaneous documentation, "ballpark guesstimates", or unverified, undocumented testimony may be insufficient.

Best Practices for Real Estate Professionals

The ability to claim PAL deductions and avoid being subject to the NIIT can result in significant tax savings. Maintaining complete and accurate records that establish REP status and material participation are essential. Taxpayers should also consider a timely aggregation election for multiple properties. Keeping contemporaneous records on hours worked in and outside of one’s real estate business and detailing the specific services performed in each activity is the best way to stay in compliance with these rules. While contemporaneous records are not required, many tax court cases demonstrate that taxpayers who prepare logs after the fact based on estimates often face difficulties meeting the hour requirements.