The effect of the Revenue Reconciliation Act of 1993 on real estate owners.

• Author: Sage, Judith A.

The Revenue Reconciliation Act of 1993 (RRA) has had a significant effect on real estate owners. Certain rental activity losses that were treated as passive activity losses (PALs) can now be charged against salary, interest and dividends, as well as passive income, and specified discharges of indebtedness from real property business debt can be excluded from a debtor taxpayer's gross income. In addition, there is a permanent extension and modification of the low-income housing credit, an increased recovery period for depreciation of nonresidential real property, and an expansion of state and local government authority to issue qualified mortgage bonds (QMBs).

This article will discuss the effect of these changes on the real estate industry and offer planning recommendations.

A PAL generally is not deductible from active income for taxpayers who do not materially participate in the conduct of a trade or business (e.g., limited partner in a limited partnership). Under pre-RRA law, "passive activity" included all rental activities (with two exceptions), regardless of the level of the taxpayer's participation. Congress considered this situation to be unfair, and modified the PAL rules to provide relief to real estate professionals.(1) Taxpayers involved in a real property trade or business who meet special eligibility requirements can offset losses from rental real estate activities against nonpassive income (e.g., wages, interest and dividends).(2)

* Eligibility requirements

This special treatment is allowed only for a real property trade or business (rental real estate), defined in Sec. 469(c)(7)(C) as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage activity. The rental of personal property (e.g., computers, copiers) does not qualify for the special treatment.

To qualify, the taxpayer must materially participate in the rental real estate activity. According to the RRA Conference Report, material participation has the same definition as under prior law, i.e., the taxpayer must be involved in the operation of the activity on a regular, continuous and substantial basis.3 Participation generally includes any work customarily performed by the taxpayer or his spouse in an activity owned by the taxpayer.(4) However, if the work is not customarily performed by the owner and its main purpose is to avoid the disallowance of passive losses or credits, it will not be treated as participation, nor will work performed in an individual's capacity as an investor (e.g., reviewing financial reports in a nonmanagerial capacity).(5)

The RRA provisions apply to taxpayers who perform (1) more than 50% of their personal services during the tax year in the rental real estate business in which they materially participate (the 50% test), and (2) more than 750 hours of services during the tax year in the rental real estate business in which they materially participate (the 750-hour test).(6)

Example 1: D, who is semiretired, works 700 hours a year in his profession. He spends another 800 hours a year related to the operation of an office building in which he is a 40% owner. Since D spends 53% (800 hours / (700 professional hours + 800 real estate hours)) of his personal service hours related to the office building, he satisfies the 50% test. In addition, by performing more than 750 hours of service related to the management and operation of the office building, he meets the 750-hour test. Because D satisfies both tests, he will be allowed to deduct a loss from the office building against his nonpassive income (e.g., professional salary, interest or dividends).

If D's professional service increases to 900 hours, he would be spending only 47% (800 / 1,7001 of his personal service hours related to the office building. Having failed the 50% test, D would no longer be an eligible taxpayer.

In applying the eligibility test, an employee's personal service is not treated as performed in a real property trade or business unless the employee is at least a 5% owner in the employer's business.7

Example 2: R is employed by a real estate business in which she owns a 1% interest. She works 2,000 hours a year for the business and has no other job. Even though R meets the 50% and 750-hour tests, she is not eligible for the passive loss exception because she is an employee who owns less than a 5% interest in the business.

Under pre-RRA law, closely held C corporations (other than personal service corporations) could offset PALS against active income, but not against portfolio income. The RRA allows eligible closely held C corporations to offset qualified rental real estate losses against portfolio income, as well as against active income. A closely held C corporation will satisfy the eligibility test if, during the tax year, more than 50% of the corporation's gross receipts were derived from a real property trade or business in which the corporation materially participated.(8)

A married couple filing a joint return will meet the eligibility requirements only if, during the tax year, one spouse separately satisfies both the 750-hour and 50% tests. However, the modification of the law does not change the current rule that participation of a taxpayer's spouse is taken into account in determining material participation.(9)

Example 3: H, who is retired, is a 30% owner of an apartment building. He spends 730 hours performing services related to the building, which is more than 50% of his personal service hours for the year. W, who is semiretired, is a 10% owner of the same apartment building, and spends 100 hours performing services related to it, which represents 40% of her personal service hours for the year. H and W are married, so that their personal service hours are combined to satisfy the material participation test. However, because neither spouse has performed more than 750 hours related to the apartment building, and they are not eligible to combine their personal service hours to meet the 750-hour test, H and W are not eligible for the...