By Samantha Ramirez, CPA, Manager, Tax & Advisory
ASL Real Estate Group
General Passive Rules
The general passive activity rules under Internal Revenue Code Section 469 define passive activities as any trade or business in which the taxpayer does not materially participate, OR a rental activity without regard to the level of participation. Passive activities that produce losses, can only be offset against passive income. If the taxpayer has no passive income, the losses will be suspended until the activity is sold in a taxable transaction.
This creates an unfavorable situation for taxpayers that have losses from rental activities. However, there is a very beneficial exception for taxpayers that can qualify as a “Real Estate Professional” (REP). This exception, allows taxpayers that materially participate in a real property trade or business (RPTB) to offset nonpassive income, such as wages or investment income with losses from their rental activities.
Examples of RPTBs include real property development, redevelopment, operation, management, leasing, brokerage, construction, reconstruction, acquisition, rental, conversion, operation and management. If a taxpayer participates in one of these activities, the taxpayer must apply three tests in order to qualify as a REP.
Real Estate Professional Tests
The taxpayer must meet three tests to qualify for the special status as a REP:
- Material participation test
- Personal services test
- Minimum hour test
Material Participation
In the first test, the taxpayer must establish material participation in a RPTB. The regulations offer seven tests to satisfy the material participation requirement. The taxpayer need only to satisfy one of the following to materially participate:
- The individual participates in the activity for more than 500 hours during the tax year;
- The individual’s participation was substantially all the participation in the activity of all individuals for the tax year, including any individuals who do not own interests in the activity.
- The individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation is more than the participation in the activity of any other individual for the year, including individuals who are not owners in the activity.
- The activity is a significant participation activity (at least 100 hours in each activity), and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the tax year;
- The activity is a personal service activity and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the taxable year. A personal service activity is an activity that involves the performance of personal services in fields where capital isn’t a material income-producing factor (i.e. health, law, engineering, architecture, accounting); Note: This test not relevant for REP.
- Based on all of the facts and circumstances the individual participates in the activity on a regular, continuous, and substantial basis during the year.
For married taxpayers, a spouse’s hours performed in the RPTB will be counted for the material participation standard. Even if the spouse has no ownership interest in the activity, the spouse’s hours are considered in determining this first step.
Once material participation is established in the RPTB, the taxpayer must meet the next two quantitative tests in order to be considered a REP.
Personal Services – More Than Half Test
For this test, more than half of the personal services performed by the taxpayer in all businesses during the year, must be performed in a RPTB with material participation. Personal services performed as an employee do not count unless the individual owns at least 5% of the business.
The hours spent on real estate activities must exceed the hours spent on non-real estate activities. For example, if a taxpayer works 2,000 hours a year as an attorney, it would be difficult to spend 2,001 hours in a RPTB. This test keeps those working full-time in non-real estate industries, from qualifying as a REP.
More Than 750-Hour Test
Lastly, the taxpayer must perform more than 750 hours of services during the year in RPTB in which the individual materially participates. The hours used to determine material participation also count for the 750-hour test, except that spouses’ hours do not count. The taxpayer alone must satisfy the 750-hour requirement.
The time spent managing and operating the rental activity can count towards both quantitative tests. If the taxpayer spends over 750 hours working with their rentals, and does not have another job or multiple jobs requiring over 750 hours, they could qualify as a REP.
Grouping Activities
If the taxpayer participates in multiple rental activities, the material participation standard is applied separately for each rental. It can be difficult for taxpayers to perform the required number of hours to satisfy the material participation tests for each RPTB on their own. Fortunately, there is a grouping election that allows taxpayers to combine multiple rentals into one activity.
If an economic unit can be established for all of the taxpayer’s rental activities, the taxpayer can elect to group these activities into one. As a result, the material participation tests will be applied to all the taxpayer’s RPTBs treated as one single activity. With the hours spent on the grouped activities combined to meet the material participation standard, it is more likely the taxpayer will also meet the personal services and minimum hours tests, in order to qualify as a REP.
It is important to note that once the election to group activities has been made, it is binding for all future years and generally cannot be changed. Therefore, all the individual facts and circumstances should be carefully considered before making this election.
Real Estate Professional Example
The requirements to qualify as a REP and deduct rental losses can be illustrated in the following example.
John is a real estate developer and works 2,000 hours per year as a developer. He also owns four rental properties that his spouse manages and spends 130 hours on each rental. All four rentals produce a loss. On their own, the rentals do not rise to the level of material participation.
Since John spends more than 2,000 hours as a developer, a RPTB, he would be considered to materially participate in the development business. His 2,000 hours are more than half of his hours in all businesses and exceed the 750-hour requirement, so John would be considered a Real Estate Professional.
John elects to group all four of his rental activities into one economic unit so the hours for the rentals can be combined. His spouse spent over 500 hours (520 in total) devoted to their rental activities so the material participation requirement has been met. The rental losses can be used to offset income from his wages or investment income.
Caveats
- There is currently a federal limitation of $578,000 (joint and $289,000 single) on “excess business losses”. This limitation will restrict the amount of rental losses that can be deducted in excess of a taxpayer’s other income. Unused losses are carried forward.
- California does not conform to the special treatment of rental losses for REP.
- The rules discussed here do not apply to short-term rentals (for example-Airbnb or VRBO).
Contact Us
The tax laws for passive activities can be unfavorable for owners of rental real estate generating losses, but when qualifying as a Real Estate Professional, taxpayers can overcome the limitations for deducting rental losses.
If you have questions about the information outlined above, Abbott, Stringham & Lynch’s Real Estate Group can help. For additional information please contact us. We look forward to hearing from you!