Real estate professionals: avoiding the passive activity loss rules.

• Author: SkarbHk, John H.

Individuals who participate in passive activities may be limited in the amount of losses and credits that they may claim on their income tax returns. Under Temp. Regs. Sec. 1.469-1T(e)(1), an activity is classified as passive if the activity is (1) a trade or business activity in which the taxpayer does not materially participate during the year or (2) a rental activity

Income and losses arising from any rental activity are generally considered passive(1) One exception to this rule applies to real estate professionals: "If the taxpayer qualifies as a real estate professional, the taxpayer's rental real estate activity escapes the per se rule otherwise applicable to rental activity."(2)

A taxpayer will be considered a real estate professional if (1) more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.(3)

Although the Code does not refer to individuals meeting this test as real estate professionals, various IRS regulations and publications(4) and the Tax Courts(5) refer to the taxpayers in real property businesses who meet the stipulated statutory requirements as real estate professionals.

The passive activity rules limit the amount that certain taxpayers(6) may deduct or claim as a credit arising from a passive activity. A taxpayer is allowed to deduct passive activity losses only to the extent of the taxpayer's passive activity income arising from all passive activities.(7) A taxpayer can use tax credits arising from passive activities during the current tax year only to the extent of the taxpayer's regular tax liability arising from the taxpayer's passive activities during that year.(8) The excess of the passive activity loss over the taxpayer's passive activity income, plus the disallowed passive activity credit, is treated as a deduction or credit in the next year.(9) A suspended passive loss can offset income from an activity in the following year even if the activity is no longer treated as passive.(10) When a taxpayer disposes of his or her entire interest in the passive activity, he or she generally will be allowed to claim the disallowed passive activity loss.(11)

A taxpayer may be able to avoid certain taxes by being classified as a real estate professional. Income arising from "rentals from real estate" is excluded from the definition of self-employment income for the purpose of the self-employment tax.(12) Additionally, the Sec. 1411 tax on net investment income does not apply under a safe-harbor provision for real estate professionals who meet certain criteria.

For tax years beginning in 2013 and later, a 3.8% tax (13) is imposed on the net investment income of taxpayers whose modified adjusted gross income (MAGI) (14) exceeds certain statutory amounts. A married couple who file a joint income tax return and whose MAGI is greater than $250,000, and a married individual filing separately whose MAGI is greater than $125,000, will be subjected to this tax if they have net investment income. In all other cases, individuals with MAGI greater than $200,000 will be subject to the tax on their net investment income.(15)

Trusts and estates will be subject to the tax on their net undistributed unearned investment income if their MAGI amount exceeds the amount at which the highest income tax bracket is imposed on a trust or an estate.(16) In 2014, a trust or estate will be in the maximum tax bracket of 39.6% when its income exceeds $12,150.(17)

A taxpayer's net investment income includes interest, dividends, annuities, royalties, and rent.(18) It also includes other income from a trade or business that is a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities (19) and the gain resulting from the disposition of property held in these types of trades or businesses.(20) Other income arising from a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities is not included in net investment income, nor is the gain from the disposition of property held in such a trade or business.(21)

Recently issued regulations provide a safe-harbor exception to this new net investment income tax for certain real estate professionals. For a real estate professional who participates in a rental real estate activity for more than 500 hours during the tax year or who participated in such real estate activities for more than 500 hours in five or more years during the 10 immediately preceding tax years, the gross rental income and gain or loss resulting from the disposition of property used in the rental real estate activity will be treated as arising from an active trade or business.(22) As a result, this income will not be included in the taxpayer's net investment income.(23)

This article starts with a discussion of the passive activity rules as applied to non--real estate activities, including a review of the material participation tests, which also apply to rental real estate activities. The article next discusses the application of passive activity rules to real estate activities, including a review of statutory and regulatory criteria to qualify as a real estate professional, making an election to classify all rental activity as a single activity, and the relaxation of the passive activity rules for rental activity for a taxpayer who actively participates in the activity. The next section discusses issues and recent tax cases involving a taxpayer's burden of proving that the taxpayer is a real estate professional and that the taxpayer materially participates in rental real estate activities. In the majority of those recent cases, the taxpayers' claimed losses arising from activities were disallowed because they failed to provide sufficient, credible substantiation of their participation in the activities. Finally, the article discusses the imposition of accuracy-related penalties in those court cases.

The Passive Activity Rules and the Material Participation Test In General

To avoid the classification of an activity as passive, taxpayers engaged in the rental of real estate must overcome two hurdles. First, the taxpayers must establish that they qualify as real estate professionals to avoid the general rule that all rental activity is per se passive.(24) Second, if the taxpayer qualifies as a real estate professional, the taxpayer must establish that the taxpayer materially participated in the rental real estate activity.(25) If the taxpayer does not meet both of these requirements, any losses that arise from the rental activity will be considered passive and will be subject to the passive activity loss limitation.(26)

In a number of recent cases, the rental real estate activities were deemed passive because the taxpayers were unable to substantiate that they were real estate professionals.(27)

Material Participation Test Under the Temporary Regulations

Temp. Regs. Sec. 1.469-5T(a) provides that a taxpayer can establish material participation in an activity by satisfying one of seven tests:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such inQdividual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of [Temp. Regs. Sec. 1.469-5T(c)]) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of [Temp. Regs. Sec. 1.469-5T(d)]), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in [Temp. Regs. Sec. 1.469-5T(b)]), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

A taxpayer bears the burden of establishing material participation by reasonable means. To prove that a taxpayer may not have materially participated, IRS agents are directed in passive activity cases to "[1]ook for time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc."(28)

To meet the seventh test under Temp. Regs. Sec. 1.469-5T(b)(2)(iii), the facts-and-circumstance test, the taxpayer must participate in the...