Real estate professionals: do their rentals qualify for nonpassive status?

• Author: Prentice, Kristin

Taxpayers who make their living in a trade or business related to real property are held to a different standard than other taxpayers when it comes to the rental passive activity loss rules of Sec. 469. Practitioners often misunderstand that the activities that qualify a taxpayer for the favorable treatment may not be the activities that would otherwise be subject to the passive activity loss limitation. Therefore, taxpayers who work in any business related to real property stand a better chance of treating certain otherwise passive activities as nonpassive.

The real estate professional exception to the passive activity loss rules is what creates this double standard. Generally, the passive activity loss rules (Sec. 469) treat rental real estate as a passive activity. As such, rental losses can only reduce passive income. By qualifying for the real estate professional exception, the taxpayer gains the ability to offset rental real estate losses against ordinary and portfolio income. In order to take advantage of the real estate professional exception, the taxpayer must meet three requirements:

* Over 50% of the taxpayer's personal services during the tax year are performed in real property trades or businesses in which he or she materially participates;

* The taxpayer must perform more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates; and

* The taxpayer materially participates in the rental real estate activity (Sec. 469(c) (7)(B) and Regs. Sec. 1.469-9(e)).

Real Estate Professionals

The first two requirements determine the taxpayer's status as a real estate professional. They focus on the amount of time spent in real property trades or businesses. The term "real property trade or business" is broadly defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business (Sec. 469(c)(7)(C)). Generally, qualifying taxpayers work as real estate brokers and agents, general and specialty contractors, land developers, property managers, those engaged in property acquisition, etc.

If a taxpayer spends most of his or her time in any of these industries, the activities may qualify unrelated rental properties as a nonpassive activity. Qualified real estate professionals often overlook the fact that they are able to treat their unrelated real estate rentals as...