Owning rental properties is a common way to increase one’s asset portfolio while also providing an income stream. Understanding how the rental activities are treated for tax purposes is important. Many claim they are a real estate professional or want to be treated as a real estate professional without fully understanding the associated requirements. This article discusses why one may want to be classified as a materially participating real estate professional and the requirements to do so.
PASSIVE INCOME AND LOSSES
Generally, rental activities are considered passive. Passive losses can only be offset by other passive income. This means, if you have a rental property that generates a loss, the loss cannot be used to reduce your nonpassive or portfolio income. Items such as wages, business income (sole proprietors), capital gains, interest, or dividend income, etc. Nor can losses from nonpassive income offset the income earned from passive rentals.
Passive losses in excess of passive income are disallowed and are carried forward to be used in future years when there is passive income. This can be a surprise to taxpayers, especially when a cost segregation study is performed with the hope of generating losses from the rental activity to help offset other taxable income in the current tax year. Depending on the taxpayer’s situation, the loss may not be deductible. Instead, the loss is carried forward to offset future passive income.
REAL ESTATE PROFESSIONAL
The Internal Revenue Code (IRC) Section 469(c)(7) has an exception to this rule that allows rental activities to be treated as nonpassive if the taxpayer is a materially participating real estate professional. This exception requires a real estate professional to use the losses stemming from rental activities to offset nonpassive income. This would allow the losses from the rental activity to offset the income from items such as wages, business income, interest, and dividend income.
This leads to the main question of “what is a real estate professional?” The requirements for a real estate professional are discussed in IRC Sec. 469(c)(7)(B). For an individual to qualify, this section states that:
- 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 services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
The first point is often the hardest hurdle for many to reach. If a Taxpayer has a full-time job in a non-real estate job, then they will not be able to meet the first hurdle of performing at least 50% of their services in a real property trade or business. This makes it important to understand which trades or businesses count towards being a real estate professional. Real estate trades or businesses are defined in IRC Sec. 469(c)(7)(C) as those that include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Some distinctions between “brokerage” services should be made. In Agarwal v. Commissioner of Internal Revenue, the Court concluded that Congress meant “brokerage” to be used in its common or ordinary meaning. The Court said:
“…for purposes of section 469, the ‘business’ of a real estate broker includes, but is not limited to: (1) Selling, exchanging, purchasing, renting, or leasing real property; (2) offering to do those activities; (3) negotiating the terms of a real estate contract; (4) listing of real property for sale, lease, or exchange; or (5) procuring prospective sellers, purchases, lessors, or lessees.”
Real estate agents typically meet those definitions. Thus, a real estate agent that materially participates in his/her real estate practice would count the time spent as a real estate agent as a real property trade or business for the Section 469(c)(7)(B) thresholds.
However, Chief Counsel Advise (CCA) 201504010 released on January 23, 2015, states that “a mortgage broker who is a broker of financial instruments is not in a real property brokerage trade or business within the meaning of IRC Sec. 469(c)(7)(C).” In short, brokerage services that bring borrowers and lenders together for mortgage loans do not qualify as an activity that counts towards being a real estate professional.
MATERIAL PARTICIPATION
There are two material participation hurdles for real estate activities to be treated as nonpassive. The first is the 50% and 750 hour tests as discussed earlier per IRC Sec. 469(c)(7)(B). Meeting these thresholds indicates that the taxpayer qualifies as a real estate professional.
The second test pertains to each real estate activity of the Taxpayer. Each real estate activity must meet the material participation rules as set forth in Reg. 1.469-9(b)(5). There are seven tests that can be used to determine if one materially participates in an activity. These tests are listed in Reg. 1.469-5T. A discussion about these seven tests is out of the scope of this article.
The material participation requirement is calculated on an activity-by-activity basis. For example, a Taxpayer owning a home building business who also personally owns two residential rental properties has three separate real estate activities. The home building business is one activity and each of the rental properties is considered a separate activity.
Assuming the home building business is Taxpayer’s full-time job, he would meet the material participation thresholds of IRC Sec. 469(c)(7)(B) and would be considered a real estate professional. The next step is to determine if he materially participates in all three activities.
There is a good chance that Taxpayer would not meet the material participation rules per Reg. 1.469-9(b)(5) for each of the residential rental properties on a separate standalone basis, and the income or any loss generated by those rental activities would be considered passive.
GROUPING ACTIVITIES
There is an election under Reg. 1.469-9(g) that allows a real estate professional to combine all real estate activities into one activity for testing material participation. This would allow the home builder discussed above to group the home building activity with the two rental activities into one. Now, all the services performed by Taxpayer on the home building business as well as the rental properties would be combined for determining material participation under the rules in Reg. 1.469-9(b)(5).
For example, one of the material participation tests found in Reg. 1.469-5T includes working more than 500 hours on an activity in the current year. By combining Taxpayer’s full-time home building job with the time spent on his rental properties, the material participation threshold would be met. However, Taxpayer may not participate more than 500 hours on each of the rental properties separately. By making the grouping election, Taxpayer now qualifies as a materially participating real estate professional, and all of the real estate activities would be treated as nonpassive. This means any losses from the rental properties could offset the income from the home building business or vice versa.
The grouping election is binding for the Taxpayer for the current year and all future years unless there is a material change in Taxpayer’s facts and circumstances.
SPECIAL NOTE
The hours spent managing short-term rental properties (average rental term is 7 days or less, or average rental term is 30 days or less and significant personal services are provided), are not considered for the 750 hour test of IRC Sec. 469(c)(7)(B). Short-term rental properties are considered trade or business property rather than rental activity property per Temp. Reg. 1.469-1T(e)(3)(iii) for this test.
Feel free to reach out to Virtual Peak Tax Advisors® if you would like assistance on this topic.