Everyday people misinterpret the tax code. It does not matter if you are a bookkeeper, accountant, unlicensed tax practitioner, Enrolled Agent, CPA, tax attorney, or even a Tax Court Judge, the tax code is complicated and confusing and many of us struggle understanding it, much less applying it in practicality.
Those of us that are true students of the code find themselves enjoying the fact that new opportunities to learn are present themselves almost every day. This could not be truer than with “real estate professionals” and the Internal Revenue Code, specifically section 469.
Qualifying as a real estate professional under IRC 469 is advantageous to taxpayers as they forego passive activity loss limitations from rental activities, no IRS Form 8582. Not only that, but real estate professionals can exclude rental income from the 3.8% tax on net investment income, no IRS Form 8960.
The real estate professional rules inside IRC section 469 have been litigated quite a bit. While no one rule, standing on its own, is particularly troublesome, many practitioners, the IRS and even the Tax Courts it seems misunderstood how to interpret the rules collectively in applying them to real life situations.
IRC 469 and the Real Estate Professional
What is a Real Estate Professional? In reviewing James F. Moss, et ux. v. Commissioner 135 TC No. 18 to be a real estate professional, a taxpayer must meet two requirements:
(1) More than one-half of the taxpayer’s personal services must be performed in real property trades or businesses in which he materially participates; and
(2) The taxpayer must perform more than 750 hours of service in real property trades or businesses in which he materially participates.
If both tests are met, the taxpayer is allowed to deduct his loss in full for the rentals in which he materially participates.
The regulations for §469 state the taxpayer can establish his participation in an activity by any reasonable means. Strict time reports and logs are not required if other reasonable means can establish the participation under Reg. §1.469-5T(f)(4).
Rental properties are generally considered passive activities under §469(c)(2) regardless of the number of hours a taxpayer participates in the activity. However, §469(c)(7) provides an exception for real estate professionals while §469(i) allows for a special $25,000 allowance for taxpayers who actively participate in the rental activity.
In this case James Moss worked as a full-time nuclear technician. He also owned four separate rental properties. Mr. Moss claimed that his actual time spent on the rental properties PLUS his ‘on call’ time to ‘be available’ to work the rental properties put him over the 750 hour/year threshold qualifying him as a real estate professional. The Court sided with the IRS stating that in order to satisfy the 750-hour test, the taxpayer must actually perform services for the rental properties. Since Moss did not actually perform any services while “on call,” he cannot use the “on call” time towards the 750-hour test. As such, he did not have enough hours and was disallowed real estate professional status.
Generally speaking under IRC Section 469, all rental activities are treated as passive, regardless of the individual owner’s extent of participation, material or otherwise. The impact of this is that rental losses can only be offset by other sources of passive income. If the taxpayer does not have enough passive income to fully offset passive losses from rental activity then those excess losses are suspended in the current tax year and carried forward to future years.
Unless of course the taxpayer truly earns their living in real estate trades or businesses as per IRC 469, then they are allowed to claim rental losses without limitation. These taxpayers are deemed ‘real estate professionals’ as per the tax code.
So how do we determine if someone is a real estate professional for income tax reporting purposes?
As per IRC Section 469(c)(7) two quantitative standards must be met in order for a taxpayer to qualify as a real estate professional.
- For the tax year in question greater than one-half of the personal services the taxpayer delivers in all trades or businesses must be in real property AND the taxpayer MUST materially participate in those activities. In other words to be a real estate professional as per the IRC the tax payer must spend more hours on real estate activities than non-real estate activities.
- You must also invest at least 750 hours of documented time providing real property business as a material participant in the tax period. These hours are best documented in a log by tax year.
The concept of real property trades or businesses includes more than the rental of property. IRC 469 lists other activities including:
The taxpayer is NOT required to be a landlord to be deemed a real estate professional for income tax purposes, nor do they actually have to be in possession of a real estate license.
The standards a real estate professional must adhere to under IRC 469 are rooted in the concept of “material participation” in real property trade or business.
Treasury Reg. Section 1.469-5T, defines seven ways to establish material participation in a trade or business:
- You participate in the activity for more than 500 hours during the year,
- Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
- Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than you,
- 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.
- You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,
- For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
- A generic facts and circumstances test.
Generally during the tax year in question for income tax purposes real estate professionals must:
- Have a for profit motive in a real property trade or business.
- Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T above.
- Invest more time in their real property trades or businesses than their day job and be more than 750 hours.
A taxpayer owns one large 90 unit commercial building and spends 2,000 hours managing and maintaining the building for the year as a defined primary job, when the building kicks off a $800,000 rental loss the taxpayer is a deemed real estate professional permitted to use the loss in full without limitation.
The tests are met as rental is defined as a real property trade, the taxpayer clearly meets the hours test of Reg. Section 1.469-5T, this is clearly the taxpayer’s primary job as 2000 in the tax year are invested in a profit motive.
Qualifying as a Real Estate Professional v. Non-Passive Real Estate Holdings
What many taxpayers have a difficult time understanding is that 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 NECESSARILY passive regardless of your level of participation.
Qualifying as a real estate professional helps to prove that the taxpayer materially participates in their rental activities, and can treat them as non-passive for income tax purposes.
If in the above example, assume the following:
- The taxpayer spent 2,000 hours in the real estate trade or business as a construction manager as a day job
- The taxpayer happened to own one rental property in which only 50 hours was invested in the tax period working with a full time property manage,
- The taxpayer would still qualify as a real estate professional, by virtue of his 2,000 hours spent materially participating in his construction business.
- However simply qualifying as a real estate professional is not enough to convert rental loss to non-passive status.
- To convert rental loss to non-passive status the taxpayer must also substantiate material participation in the rental activity.
- Having only invested 50 hours in rental property activity, and with consideration that other people (property managers) spent more time than him on the activity the taxpayer cannot establish material participation.
- As a result, even though the taxpayer is a real estate professional, rental losses remain passive and subject to the annualized loss limitation of $25,000.
These rules are a little mind numbing when you have only one rental property in the tax period. When multiple rental properties are involved, qualifying as a real estate professional becomes profoundly more complicated.
IRC Section 469 states that materially participating in the ONE activity requires 500 hours of the taxpayer’s time. But if you have ten rental properties or partnership interests for that matter you cannot reasonably expect to spend 500 hours in each activity. 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 by electing to group your activities and subsequently collectively aggregate the total hours for the tax period invested in the grouped activities.
Taxpayers may group activities as they see fit, provided grouped activities represent an “appropriate economic unit.” This means that generally rental activities are not grouped together with non-rental activities.
- Grouping together rental activitiescan be meaningless 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.
- Qualifying as a real estate professional does not make your rental properties non-passive
- Qualifying as a Real Estate Professional creates the opportunity for the taxpayer to establish that they materially participate in their rental activities in which case their losses will be treated as NOT BEING PASSIVE.
Reg. Section 1.469-9(g) provides that for purposes of establishing material participation, a real estate professional may elect to treat all interests in rental activities as one activity.
In contrast to the Reg. Section 1.469-4 election addressed above, the Reg. Section 1.469-9 election is an “all or nothing” election in that requires the taxpayer to group all of the rental activities together, or not at all.
If the taxpayer makes the -9 grouping election, material participation in the rental activities is determined by summing the hours of time the taxpayer spent on all rental activities.
If the election is not assert, the taxpayer must establish material participation in each separate activity.
Regardless of the asserted election (“economic unit” or “all”) the taxpayer must:
- Participate in a real property trade or business.
- Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T.
- The time spent participating in real property trades or businesses must exceed the time spent on the “day job” and be greater than 750 hours in the tax year.
Tax Court Cases
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).”
In Jafapour v. Commissioner, T.C. Memo 2012-165 and Hassanipour v. Commissioner, T.C. Memo 2013-88 the Tax Court employed a similar approach.
In both cases the Tax Court is using the -9 election to determine if a taxpayer qualifies as a real estate professional.
The problem is that the regulations make clear that the -9 election becomes relevant only after a taxpayer has satisfied the two tests required to be a deemed Real Estate Professional, for the sole purpose of determining if the taxpayer materially participates in his rental activities.
Therefore, the court is asking the taxpayer who fails to file a grouping election to spend more than:
- half his/her time working on each rental activity, AND
- 750 hours on each rental activity
This is not what the Code and regulations require, and placing this burden on a taxpayer can result in incorrect conclusions.
If a taxpayer owns five commercial rental properties and invests time solely as follows:
- 600 hours on property A
- 300 hours on property B
- 300 hours on property C
- 250 hours on property D
- 300 hours on property E
Because the taxpayer does nothing else for the tax period under Reg. Section 1.469-5T the taxpayer materially participates in each property.
Even though the taxpayer materially participates in each separate activity, because there was no election to group the activities together under Reg. Section 1.469-9 when each property produces a loss for the year the taxpayer must measure his qualification as a real estate professional on a property by property basis.
Because the taxpayer did not spend more than 750 hours in any one property, he or she is not a real estate professional, and all of his losses will be treated as passive.
If the taxpayer grouped their properties:
- The taxpayer meets the standard of participating in a real property trade or business as a leasing agent for the properties in question.
- The taxpayer materially participates in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T.
- The time spent materially participating in real property trades or businesses exceed the time spent in the taxpayer’s ‘day job’ if you will as this is all the taxpayer does. And in excess of 750 hours was invested by the taxpayer materially participating in real property trade or business.
This should all be determined before addressing the implications of making the “all or nothing” grouping election of -9.
The taxpayer 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.
This is because the election -9 is only relevant when a taxpayer who has qualified as a real estate professional under the two quantitative tests of Section 469(c)(7) must take the next step of establishing that he materially participates in his rental activities.
In CCA 201427016, the IRS 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.
The IRS concluded that the determination of whether a taxpayer satisfies the real estate professional rules is unaffected by the 1.469-9 grouping election and that the grouping election is relevant only after the taxpayer qualifies as a real estate professional to determine if the taxpayer materially participates in their rental activities.
Hopefully, you’ve learned that the “all or nothing” grouping election of Reg. Section 1.469-9 applies only after you determine if you are a real estate professional as well as the difference between being a real estate professional and material participation.