An individual's rental real estate activities, including those owned through pass-through entities, automatically fall under the passive activity loss (PAL) rules regardless of whether the taxpayer materially participates in the activity. In other words, it does not matter how much time is spent engaged in the activity, rental losses are deductible currently only to the extent of rental income and income from other nonrental passive activities.
There are two important exceptions to this rule: (1) $25,000 rental real estate exception for a taxpayer with adjusted gross income (AGI) of $150,000 or less and (2) the special exception for qualifying real estate professionals. The first exception generally is of little or no benefit since it is limited to $25,000 or less of annual losses. Moreover, it begins to phase out at $100,000 of AGI and becomes fully phased out at $150,000 of AGI. As a result, this post will focus on the second, more valuable exception; since this is generally the exception taxpayer’s will need to satisfy to deduct their rental losses on a current basis.
Exception for Qualifying Real Estate Professionals
Real estate professionals may treat otherwise passive rental real estate activities as nonpassive if the taxpayer materially participates in the rental activity. Losses from such activities can be used to offset wages, interest, and other nonpassive income. This treatment is only available to eligible individual taxpayers who are considered to materially participate in the rental real estate activity. An individual is an eligible taxpayer for any tax year if:
- More than 50% of personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.
Because the exception applies to individuals with substantial time commitments to real estate, it may appear relief is unavailable if the taxpayer owns multiple properties or is a partner or member in multiple activities. However, if the taxpayer makes a special election to aggregate rental real estate activities, the numerical tests are applied as if all of the activities constitute a single rental business.
A real property trade or business is broadly defined to include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. The Treasury Regulations provide that a facts and circumstances test applies in determining the taxpayer’s real property trades and businesses and that any reasonable method may be used in applying that test.
To be eligible for these special rules, the taxpayer must materially participate in real property trades or businesses rather than participate in business activities involving real estate transactions. This means the benefits of these rules are unavailable to individuals who are only peripherally involved in real property trades and businesses (i.e., attorney who specializes in real estate transactions).
The IRS has argued that real estate agents do not materially participate in real property trades or businesses. However, in Shri G. Agarwal, TC Summary 2009-29, the Tax Court held that a licensed real estate agent’s activities counted towards satisfying the real estate professional’s exception to the passive activity rules, even though the agent was not a broker under state law. Therefore, real estate agents should qualify for the qualifying real estate professional exception (assuming they satisfy the more-than-50% and more-than-750-hours tests).
It is important to note, however, that if a taxpayer is trying to qualify as a real estate professional on the basis of a rental real estate business with multiple rental real estate interests and he or she has a full-time job unrelated to those activities, the IRS will likely argue that it is impossible to qualify as a real estate professional. The IRS typically takes this position more out of spite, than law. As long as the election to treat all rental real estate interests as a single activity is made and the taxpayer meets the numeric tests, it should not matter if he or she also has a second occupation. Nevertheless, taxpayers should prepare for an IRS challenge because most IRS agents do not (or choose not to) understand the law.
Three Steps to Qualification
Here are the three steps to determining if a taxpayer qualifies for this special exception:
- Pass Material Participation Test. To qualify for relief under the real estate professional exception, the taxpayer must first meet the material participation standard for one or more trades or businesses within the broad overall category of real property trades or businesses. This means passing one or more of the following material participation tests listed in the Treasury Regulations:
(1) More than 500-hour test.
(2) Substantially all participation in the activity test.
(3) More than 100 hour and as much participation as anyone else test.
(4) Significant participation activity test.
(5) Personal service activity and materially participated for three years test.
(6) Facts and circumstances test.
Generally, tests 1, 2, and 3 are the easiest to pass. For purposes of passing any of these material participation tests, married individuals can count participation by their spouses, whether or not a joint return is filed. Also, each interest in rental real estate is treated as a separate activity unless the taxpayer elects to aggregate all rental real estate interests into a single activity (more on that later).
- Meet Time Commitment Thresholds. To meet this second requirement, the taxpayer must meet the tax-law definition of a real estate professional by showing that:
- More than 50% of his or her personal services during the tax year were performed in real property trades or businesses in which she materially participates, and
- More than 750 hours of personal services were performed in real property trades or businesses in which she materially participates.
Personal services in real property trades or businesses means any work (other than in the capacity as an investor) in those activities including management work connected with rental real estate activities. However, personal services performed as an employee only count as personal services performed in a real property trade or business when the employee is also a more-than-5% owner of the employer.
For married couples who file jointly, one (or both) of the spouses must individually meet both the 50% and 750-hour rule. In other words, the time spent by both spouses cannot be combined to pass the 50% test or the 750-hour test (even though their time can be combined to meet the material participation standard for purposes of Step 1).
- If Necessary, Elect to Aggregate Rental Real Estate Activities. If the taxpayer fails to meet the requirements of 1 and 2 above, the taxpayer will not be considered a real estate professional and will therefore be ineligible for the special exception to the PAL rules. Thus, the third step is to "try again" (if necessary) by electing to aggregate all rental real estate activities into a single unit for purposes of passing the material participation and substantial time commitment tests. For this purpose, rental real estate interests cannot be combined with other activities such as real estate development. It is important to remember that failing to make the aggregation election for one tax year does not preclude making the election in a later year. However, once the election is made, it continues to apply for all future years in which the taxpayer is also a qualifying taxpayer unless there is a material change in the taxpayer’s facts and circumstances.
It is important to note that each interest in rental real estate is considered a separate activity unless the election is made to aggregate allrental real estate interests and treat them as a single activity. If the election is made, the combined interests are treated as a single activity for all purposes under the PAL rules.
Downside of Aggregation Election
The biggest downside of making the aggregation election is the adverse impact it may have under the so-called complete-disposition rule. Specifically, all the suspended passive losses allocable to the electing taxpayer's aggregated rental real estate interests cannot be "freed up" under the complete disposition rule until after the taxpayer disposes of substantially all of the interests. As a result, if a taxpayer has significant suspended passive losses allocable to certain properties that are likely to be sold in the near future, it may be prudent to defer making the aggregation election until after the sales are made.
Also, when one or more of the rental real estate interests is a limited partnership interest, making the election will subject the entire now-aggregated bunch of interests to the stricter material participation standards for limited partnership interests. However, this nasty little provision does not apply when the limited partnership interests generate less than 10% of the gross rental income from all of the taxpayer's rental real estate interests for the year.
The aggregation election is also inadvisable when the taxpayer’s rental real estate interests generate overall passive income rather than losses. Passive income is always good, and combining a taxpayer’s interests could result in the income becoming nonpassive.
Finally, when the taxpayer's rental real estate interests throw off an overall passive loss which can be offset by passive income from other sources, there is no need to make the aggregation election. Unlike the election to group activities into a single trade or business under the Treasury Regulations, the election to aggregate for purposes of meeting the qualifying real estate professional exception does not have to be made the first year in which the taxpayer has the activity.
How to Make the Election to Aggregate for Purposes of the Qualifying Real Estate Professional Rule
The election is made by including a statement in the original (not amended) return for a year in which the taxpayer is eligible for the real estate professional exception. Not making the election in one year in which the taxpayer is eligible does not preclude making the election in a later year. The following statement should be sufficient:
Taxpayer qualifies for relief from the passive activity loss limitation provisions under the special exception for taxpayers in real property businesses. Therefore, taxpayer hereby elects to treat all rental real estate activities as a single (aggregated) activity pursuant to Section 469(c)(7)(A) and Reg. 1.469(g)(3) .
Do Not Confuse the Aggregation Election with the Grouping Election
Treasury Regulation Section 1.469-4 allows taxpayers to group activities, provided they make up an appropriate economic unit. This “grouping election” is different from the aggregation election discussed in this post. Substantial confusion exists with respect to these two elections and some commentators mistakenly interchange them. It is important to note that these two elections are different elections for which different rules apply. Although the end result of making these elections may be similar, the grouping election is a precision tool for tax planning that must be carefully made and used. The IRS recently issued
Revenue Procedure 2010-13, which requires taxpayer to formally disclose new groupings and regroupings of activities. We’ll discuss this valuable provision and how it differs from the aggregation election (discussed above) in a future post.
Final Word
The IRS has been emphasizing the passive loss rules in recent audits and frequently misapplies the law. If you have made significant investments in rental real estate, be sure you have a tax advisor who fully understands the complexities of the law and who is not “too busy” to explain them to you. If your return is selected for audit, you are virtually assured of being denied deductions associated with your investments to the extent they exceed the income from such investments. This is true regardless of whether you are complying with the law or not.