Navigating the real estate professional rules.

• Author: Nitti, Tony

EXECUTIVE SUMMARY

* Under Sec. 469, a taxpayer only may offset losses from a passive activity against income from a passive activity. A passive activity generally includes any trade or business of a taxpayer in which the taxpayer does not materially participate and any rental activities of a taxpayer, regardless of the level of participation.

* A rental activity of a taxpayer that qualifies as a real estate professional under Sec. 469(c)(7) is not presumed to be passive and will be treated as nonpassive if the taxpayer materially participates in the activity.

* A taxpayer qualifies as a real estate professional if (1) more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are in real property trades or businesses in which the taxpayer materially participates, and (2) hours spent providing personal services in real property trades or businesses in which the taxpayer materially participates total more than 750 during the tax year.

* A real estate professional taxpayer generally must establish material participation in each rental activity separately. However, the taxpayer may elect to aggregate all of his or her interests in rental real estate for purposes of determining material participation.

* Passive income, including from rental activities, is generally subject to the net investment income tax (provided other criteria are met) unless the taxpayer is a qualifying real estate professional and the income is derived in the ordinary course of a trade or business.

* A safe harbor in such cases provides that 500 hours in the rental activity either in the tax year or in any five years (whether or not consecutive) of the immediately previous 10 years constitutes services in the ordinary course of a trade or business.

**********

Sec. 469 provides that losses from a "passive activity" may only be used to offset income from a passive activity, with any passive losses in excess of passive income for a tax year disallowed and carried forward to the next year. Included in the definition of a passive activity is any rental activity, regardless of the taxpayer's level of participation.

A taxpayer who meets the qualification of a real estate professional under Sec. 469(c)(7), however, overcomes the presumption that all rental activities are passive. As a result, since the enactment of Sec. 469(c)(7) in 1993, (1) taxpayers with rental losses have sought to meet the qualification of a real estate professional to prevent those losses from being treated as per se passive, potentially allowing the losses to be used without limitation.

On Jan. 1, 2013, qualifying as a real estate professional suddenly became meaningful even to taxpayers with rental income. On that date, the net investment income tax of Sec. 1411 became effective, levying an additional 3.8% surtax on, among other items of investment income, all passive income of a taxpayer. Thus, a taxpayer with rental income now has an incentive to qualify as a real estate professional: characterizing rental income as nonpassive to avoid imposition of the surtax. (2)

As a result, it has never been more desirable for a taxpayer with rental activities to meet the qualification of a real estate professional. Unfortunately, qualifying as a real estate professional is fraught with peril. The various terms of art, hours requirements, and quantitative tests imposed under Sec. 469(c)(7) and the underlying regulations have confused taxpayers, tax advisers, IRS agents, and even Tax Court judges, leading to an inordinate amount of litigation during the 24-year history of the provision.

This article seeks to clear up the confusion surrounding these rules by providing a step-by-step approach that tax advisers can use to determine whether a taxpayer qualifies as a real estate professional and, more importantly, if the taxpayer does qualify, whether his or her rental activities are treated as nonpassive. While discussing each step, this article reviews case law, highlighting planning opportunities and traps for the unwary. This article also discusses an important recent Chief Counsel Advice (CCA) in which the IRS revealed that it had previously misapplied a vital aspect of the real estate professional rules.

History of the Real Estate Professional Rules The Passive Activity Rules in General

Prior to passage of the Tax Reform Act of 1986, (3) tax shelters were readily available to any taxpayer with disposable income and the willingness to be a landlord. Consider the following example:

Example 1: In 1985, A, a doctor, earns wages from a medical practice of $300,000. In hopes of sheltering his wage income, A purchases a home and rents it at fair market value. The rental is low-maintenance; A is rarely required to visit the property and otherwise spends little time managing its rental. By virtue of large depreciation deductions, the rental generates a tax loss, which A uses to partially offset his wage income, significantly lowering his tax bill. The situation is a win-win for A; he generates losses largely through noncash depreciation deductions while the rental home appreciates in value.

The Tax Reform Act of 1986 put an end to such shelters, however, by enacting Sec. 469. Effective for tax years beginning after Dec. 31, 1986, a taxpayer's loss from a passive activity can only offset income from a passive activity. (4) The definition of a passive activity includes any rental activity of the taxpayer, regardless of the taxpayer's level of participation (but with an exception discussed below). (5)

As a result of the categorization of all rental activities as passive, the doctor's loss in Example 1 from his rental home would be passive. Because the doctor's wages are not passive income, (6) Sec. 469 will not permit the rental loss to offset the doctor's wage income. Instead, the loss will be carried forward until the doctor either generates passive income or disposes of the rental property in a fully taxable transaction. (7)

The Real Estate Professional Exception

After the enactment of Sec. 469 but before the addition of Sec. 469(c)(7), certain taxpayers believed they were being unfairly punished by the classification of all rental activities as per se passive. Consider the following example:

Example 2: B is a real estate developer specializing in the development of residential properties. B builds development 1 and development 2. B sells all of the homes in development 1 to customers as part of his ordinary trade or business. The homes in development 2, however, B holds and rents to families.

While B's development business generally would be considered one trade or business, as initially enacted, Sec. 469 treated B as conducting two separate activities for its purposes. The first activity is B's development and sale activity, which is nonpassive because it is a trade or business in which B materially participates. The second activity is B's development and rental activity, which under the rules of Sec. 469 is treated as per se passive regardless of B s level of participation because it is a rental activity. Thus, if B generated income from the sale of homes in development 1 and a loss from the rental of homes in development 2, before the addition of Sec. 469(c)(7), Sec. 469 generally prohibited B from using the passive rental losses to offset the nonpassive income from the sale of the homes in development 1.

B complains, of course, that he is engaged in one trade or business that encompasses multiple aspects of the real estate industry: development, sale, and rental. By not allowing B to use the losses from the rental portion of the business against income from the sale portion of the business, the law treated B differently from taxpayers in non-real estate trades or businesses, who could use losses from one aspect of their business against income from another.

By 1993, Congress recognized the inequities wrought by the per se passive treatment of all rental activities and sought to provide an exception to a narrow category of taxpayers: so-called real estate professionals. Congress added Sec. 469(c)(7), by which a taxpayer who qualifies as a real estate professional overcomes the presumption that all rental activities are passive. If the qualifying real estate professional establishes that he or she materially participates in a rental activity, the activity will be nonpassive.

General Rules

Sec. 469 defines a passive activity, in part, as:

1. Any trade or business of the taxpayer in which the taxpayer does not materially participate, (8) and

2. Any rental activity of the taxpayer except as provided under Sec. 469(c)(7). (9)

   Congress could have simply applied the material-participation standard to rental activities, as it did to all other trades or businesses, but chose not to for two reasons. First, even rental activities that yield positive cash flow often generate a tax loss due to depreciation deductions, making rental properties an ideal tax shelter.

   Second, as discussed later in this article, a taxpayer can materially participate in an activity other than real estate rental by performing only minimal personal services, provided no other individual contributes services to the activity. While most trades or businesses require a meaningful time commitment, many rental activities are so low-maintenance that a taxpayer can conduct them with very little effort. As a result, if Congress had permitted a rental activity to qualify as nonpassive via the same material-participation standard as for other activities, many taxpayers who invested minimal time in their rental properties would meet this standard, greatly hindering Congress's ability to curb the use of rental activities as tax shelters.

   As a result, a taxpayer can overcome the presumption that all rental activities are passive if the taxpayer qualifies as a real estate professional by satisfying the two quantitative tests of Sec. 469(c)(7)(B):

1. More than one-half of the...