Real Tax Savings for Real Estate Professionals and their Families
Glen E. Frost, Managing Partner
The Internal Revenue Service (IRS) considers a passive activity as any activity involving the conduct of a trade or business in which the taxpayer does not materially participate.1Rental activity is considered a per se passive activity, regardless of the taxpayer’s participation level, unless the taxpayer can demonstrate that he or she is a materially participating real estate professional (REP).2Passive activity classification prevents rental property owners from deducting net losses against their other sources of non-passive income like wages and portfolio income. Additionally, passive activity classification subjects rental property owners to the 3.8% net investment income tax (NIIT) on income and capital gains from the sale of real estate properties.3As such, rental property owners should carefully consider both REP qualification and the material participation standard and how it can help them avoid passive activity classification. Rental property owners should also consider that since rental income is excluded from the self-employment base, qualifying as a REP may allow them to avoid self-employment tax, as well.4
Non-passive treatment is available when a rental property owner both qualifies as a REP and subsequently satisfies the material participation standard. While REP qualification is rather straightforward, the rules pertaining to the material participation standard complicate matters.
(1) Who Qualifies as a REP?
Relief from per se passive classification, is available under Internal Revenue Code (I.R.C.) §469(c)(7). Under this section, taxpayers who qualify as a REP avoid the per se classification, which in turn allows them to demonstrate material participation in the real estate activities.
First, in order to establish REP status, a taxpayer must show that over half of taxpayer’s personal services performed in trades or businesses over the year were performed in real property trades or businesses in which he or she materially participated.5Second, the taxpayer must have performed over 750 hours of personal services in real property trades or businesses in which he or she materially participates.6
Note that “real property trades or businesses” is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”7Furthermore, “personal services” performed as an employee are excluded unless the employee is a 5% owner of the employer.8For REP purposes an employee of a real property trade or business must own a 5% interest in the employers outstanding stock to accumulate any satisfying hours. Additionally, only the hours worked by the employee during the period the employee is a 5% owner of the real property business will be considered in qualification as an REP.9
(2) Establishing Material Participation
If a qualifying taxpayer materially participates in rental real estate activities, then those activities are not classified as passive. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the activity’s operations on a regular, continuous, and substantial basis.10Under all of the regulatory tests below taxpayers must consider and include the hours and work performed by a spouse to meet the requirements for material participation even if the spouse owns no interest in the property.11However, labor hours performed by a spouse are excluded from the statutory 750 hour requirement to be a REP.12
Generally, seven regulatory tests may be used to demonstrate regular, continuous and substantial involvement; however, in the context of rental real estate, only the following five tests are applicable:
- (a) More than 500 Hours of Participation
This test requires the taxpayer to show that he or she spent more than 500 hours participating in the activity during the tax year.13 - (b) Substantially All Participation by Taxpayer
This test only looks to see whether the taxpayer’s participation in the activity is substantially all of the participation among all individuals in the activity during the year.14This requirement considers time worked by any independent contractors, and other associates. - (c) 100 Hours of Participation
Taxpayer is only required to prove that he or she spent more than 100 hours of participation during the tax year and that no other individual exceed taxpayer’s participation.15 - (d) Previous Classification for any Five of the Prior Ten Years
This test allows any person who has been determined to have materially participated in any five of the ten years preceding the current tax year to qualify for the current year.16This test requires no analysis of the taxpayer’s participation in the current year. - (e) “Regular, Continuous, and Substantial” Involvement17
Tax practitioners consider this the most difficult test. The regulations fail to provide a definition of “substantially all.” This test has no strict interpretation and has often lead courts to rule against the taxpayers. Prior court cases indicate that the taxpayer must prove that their participation is significant, ongoing, and the rental activity critically relies on their active participation to continue operations.
Note that the material participation standard does not include any time spent as an investor in a real property trade or business, unless the individual is directly involved in the day-to-day management or operations of the activity.18
(3) Grouping Election
Under the regulations, for purposes of qualifying as a REP, “[d]epending on the facts and circumstances, a real property trade or business consists either of one or more than one trade or business specifically described in section 469(c)(7)”19(i.e. development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, and brokerage). Thus, a taxpayer has the opportunity to group together two or more of the listed statutory activities into one real property trade or business. Note, however, that interests in rental real estate are not generally permitted to be grouped with any non-rental interests.20
Grouping is advantageous, because it allows the taxpayer to more easily satisfy the material participation standard. Basically, the more activities that can be combined into one real property trade or business, the more likely the taxpayer can fulfill the requirement for hours spent on that business.21
(4) Filing Jointly
Significantly, in the context of married individuals filing jointly, if one spouse has a full- time job in something other than a qualifying activity (thus, failing to qualify as a REP), the other spouse’s time spent in real property trades and businesses may be counted to qualify both spouses as REPs.
Per regulations, “[s]pouses filing a joint return are qualifying taxpayers only if one spouse separately satisfies both requirements of section 469(c)(7)(B).”22In other words, the qualifying spouse must independently satisfy the REP tests (i.e. “more than half of personal services” and “greater than 750 hours” tests). For instance, the IRS will not allow the spouses to combine their work hours in order to exceed 750 hours. On the other hand, regardless of whether filing jointly or not, remember that establishing material participation in trades or businesses requires consideration of hours and work performed by a spouse – even if the spouse owns no interest in the property.23
Example (Taxpayers fail REP qualification): Wife properly treats her brokerage activity and rental property as separate real property trades or businesses. She materially participates in her brokerage activity by spending 501 hours in the activity. She only spends 199 hours on her rental property; however, her Husband spends 306 hours in the rental activity. Wife must count Husband’s rental property hours to determine whether Wife materially participates in the rental activity. With a combined 505 hours in the rental activity, Wife does materially participate. However, for purposes of satisfying the “more than half of personal services” test, Wife is only allowed to count her own 199 hours. This leaves Wife with 501 hours in the brokerage activity and 199 hours in rental activity, for her own total of 700 hours. Wife fails the 750-hour requirement and does not qualify as a REP.
Example (Taxpayers qualify as REPs): Wife is an attorney with rental properties incurring $75,000 in losses each year. Wife spends most of her time working as an attorney and earns $250,000 per year. She fails to qualify as a REP under the “more than half of personal services test.” However, Wife is married to Husband and they file jointly. Husband manages Wife’s rental properties such that he independently qualifies as a REP (i.e. he meets the “more than half of personal services” and “greater than 750 hours” tests). Under the regulations, both Wife and Husband will now qualify as REPs. Since Husband’s materially participates in managing Wife’s rental properties, Wife and Husband can deduct the $75,000 loss from Wife’s income.
(5) Conclusion
A REP qualified under I.R.C. §469(c)(7), who materially participates in the activity, avoids passive classification of their rental income. A REP may deduct any net losses from qualified real estate activities from their non-passive income.
Furthermore, if a REP can also show that rental income is derived in the ordinary course of a trade or business (i.e. activity is a I.R.C. §162 trade or business), then the rental income may also be exempt from the NIIT.24The regulations provide a safe harbor with two alternatives in the NIIT context, such that: (1) if a I.R.C. §469(c)(7) REP participates in the rental activity in excess of 500 hours per year, then such income derived from the rental activity is deemed to be derived in the ordinary course of a trade or business, or (2) if the REP participated in the rental activity for more than 500 hours per year in five of the last 10 years, then the income is deemed derived in the ordinary course of a trade or business.25
The Internal Revenue Code currently allows only a $25,000 deduction of passive activity losses from non-passive income. Typically, this limit applies to real estate activities. This $25,000 allowance is reduced by 50% of the taxpayer’s income over $100,000 after certain deductions are made. Generally, taxpayers with income over $150,000 may not claim deductions for passive activities losses such as those from real estate activities. However, qualified and materially participating REPs are exempt from these limits and phase-out provisions.
If you have tax questions or concerns, contact Frost & Associates, LLC today at 410-497-5947.
1I.R.C. §469(c).
2I.R.C. §469(c)(7).
3I.R.C. §1411.
4I.R.C. §1402(a).
5I.R.C. §469(c)(7)(B)(i).
6I.R.C. §469(c)(7)(B)(ii).
7I.R.C. §467(c)(7)(C). Note that for purposes of I.R.C. §469(c), the Tax Court has ruled that 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, purchasers, lessors, or lessees.” Agarwal v. Commissioner, T.C. Summ. Opin. 2009-29, 9 (3/2/2009).
8I.R.C. §469(c)(7)(D)(ii).
9Reg. §1.469-9(c)(5).
10I.R.C. §469(h).
11I.R.C. §469(h)(5).
12I.R.C. §469(c)(7)(B).
13Reg. §1.469-5T(a)(1).
14Reg. §1.469-5T(a)(2).
15Reg. §1.469-5T(a)(3).
16Reg. §1.469-5T(a)(5
17Reg. §1.469-5T(a)(7).
18Reg. §1.469-5T(f)(2)(ii)(A).
19Reg. §1.469-9(d)(1).
20Reg. §1.469-9(e)(3).
21Note that once a taxpayer determines the grouping, he or she may not redetermine them in later years unless the original grouping was clearing inappropriate or a material change has occurred which makes the original determination clearly inappropriate. Reg. §1.469-9(d)(2).
22Reg. §1.469-9(c)(4).
23Id.
24I.R.C. §1411.
25Reg. §1.1411-4(g)(7)(i)(A), (B).
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