Why designate myself as a real estate professional? Aside from being something cool to tell the grand kids, let’s presume that you have a rental loss. It is common to have a tax loss on your rental although it cash flows, and the primary reason is depreciation. How does it affect your tax return?
Section 469 defines a passive activity as any activity that involves a trade or business in which an individual taxpayer does not materially participate. Rental income is typically considered passive, meaning that you are not directly earning the income as you would with a W-2 job or as a small business owner. Passive losses may be deducted from passive income, and from non-passive income such as wages and business income but there are limits (of course there are!). Passive loss limits for married taxpayers max out at $25,000, and that number decreases as your gross income increases.
Specifically, passive loss reduces $1 for every $2 over $100,000 adjusted gross income (AGI) and by $150,000 (for married couples) the passive loss deduction is $0. Bummer. Not all is lost however. If your rental losses are capped or disallowed because of passive loss limits, the portion exceeding the passive loss limit is carried forward on Form 8582, aggregated for each year and may be deducted in the year of disposal (sale). They may also offset future net rental income… you had losses, they were carried forward, you now have rental profits and the suspended losses can be used to offset.
Passive loss limits for single filers or for married persons who live apart for the entire tax year is $12,500. If you live with your spouse for any part of the year yet file a married, filing separate tax return the passive loss limit is $0. Not good.
There is another angle to all this, and this is the gist of this article- if you are a real estate professional as defined by the IRS, you can deduct 100% of your rental property losses and you are not capped by passive loss limits. This makes sense since your rental income is no longer passive if it is your livelihood or at least a large portion of your livelihood. In other words, the real estate professional (REP) status is essentially telling the IRS and the world that your rental activities are not something you tend to from time to time but rather are approached with the mindset of a busy business owner.
But wait! There’s more. As mentioned later in this post, when the Net Investment Income Tax (NIIT) which was introduced along with the Affordable Care Act, the real estate professional designation became an important tax planning tool all over again. Huh? If your modified adjusted gross income (MAGI) hits a certain amount, the NIIT is charged on all portfolio (interest, dividends, capital gains) and passive activity income (rentals). However, if you are a real estate professional your taxable rental income (profits) is no longer deemed passive and as such is not being taxed by the net investment income tax of 3.8%. That could be huge!
So, how do you become a real estate professional? It is not enough to simply own rentals or have a real estate license. There is a two part test… hours spent and material participation-
- Spend 750 hours on real estate activities (more than other activities such as your day job), and
- Materially participate as defined by Section 469-5T
Let’s do this!
Real Estate Professional Hours
Taxpayers are required under Internal Revenue Code Section 1.469-5T(f)(4) to provide proof of services performed and the hours attributable to those services. Here is a snippet regarding proof for material participation, and the same process can be used for substantiating real estate professional hours-
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
Second, logs cannot be retro-created. So, you must have been maintaining your logs as you performed the real estate activities. During an audit or examination if you mention things like “I jotted activities down on my log and then went back and tallied the hours in preparation for this audit” you will probably lose. You need to have maintained the written account of your hours from the beginning. Here is the case law reference- The regulations do not allow a postevent “ballpark guesstimate” in Moss v. Commissioner, 135 T.C. 365, 369 (2010).
Third, on-call hours do not count, you must “perform” an activity. The tax court has ruled that waiting for the phone to ring in case a maintenance or emergency call comes in does not count. Here’s the snippet from Kutney v. Commissioner, Tax Court Summary 2012-20 under footnote 7-
Petitioners also contend that Mr. Kutney’s ownership and management of the rental properties was a “truly full day activity” that required him to be available all day every day and that these on-call hours should count towards the 750-hour requirement. We disagree with this contention. Sec. 469(c)(7) applies where the taxpayer “performs more than 750 hours of services” rather than where the taxpayer is merely on call to perform services. Sec. 469(c)(7)(B)(ii); see also Moss v. Commissioner, 135 T.C. 365, 370 (2010); sec. 1.469-9(b)(4), Income Tax Regs.
Ok… that is hours and which ones count, etc. Let’s move on to material participation.
Material Participation
Let’s discuss active participation first. For rental properties, the issue is nearly moot since active participation relates only to rental real estate activities and is a less stringent standard than material participation. As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. Activities include new tenant approval, rental terms, repair authorizations, capital expenditures, etc. WCG CPAs & Advisors has a client whose brother handles all of the rental property matters for a condo in San Francisco- in this example, his participation did not reach the level of active participation. Said differently, if you forget that you own a rental, you likely do not actively participate.
According to the IRS Audit Techniques Guide on Passive Activities there is not a specific hour requirement. Even if you use a management company, you will be considered active if you are involved with the operation of your rental. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager or management company. In addition, the taxpayer must have at least a 10% interest in the rental activity.
To recap for married taxpayers, passive activities such a rentals or investment partnerships have a loss limit of $25,000 in offsetting non-passive income such as W-2 wages or other earnings. This is reduced $1 for every $2 over $100,000 in adjusted gross income. Any disallowed passive loss is carried forward until you dispose of the property or investment. For example, you make $120,000 at your regular job and have $30,000 in rental losses. Your passive loss deduction is $15,000 ($25,000 minus $10,000) and the remaining $15,000 is carried forward.
So active participation only matters for those taxpayers who are not limited on their passive losses. In other words, if you do not exceed the passive loss limits you only need to demonstrate active participation. However, and the primary purpose of this article, to avoid the passive loss limitations of $25,000, a taxpayer must be considered a real estate professional who also materially participates in the rental activity.
Don’t forget the reduction of net investment income tax by changing the color of money on your rental activities from passive to something other than passive. The rules for material participation are considerably more stringent, and will be discussed next. Fun!
Material Participation Audit Tests
Ok. Here we go. This is where the IRS is starting to crack down on what they deem gaming the system by self- determined real estate professionals. Section 469(h)(1) states that an individual must have “regular, continuous, and substantial” involvement in the activity to be considered materially participating.
What the heck is regular, continuous and substantial? Temporary Regulations 1.469-5T(a) gives us a hand. There are several requirements for material participation, and satisfaction of any one test will allow you to be considered materially participating. We’ll discuss each one in turn, and refer to notes from the IRS Audit Techniques Guide (ATG) for each test including case law when applicable.
1. You participated in the activity for more than 500 hours.
ATG Notes: If the taxpayer participates more than 500 hours during the year in a business, income or loss from the activity will be non-passive. Participation of both spouses is counted, but not participation of the children or employees. Participation in operations must be regular, continuous, and substantial. The examiner should determine whether the quantity of time documented is reasonable in light of other obligations.
What exactly does “regular, continuous, and substantial” mean? No definition is provided in the Internal Revenue Code or other regulations. However among Technical Advice Memorandums (TAMs) and Tax Court Cases, a general notion exists that for a taxpayer to materially participate, the taxpayer must be involved in the day-to-day management and operations of the rental activity (similar to a trade or business).
ATG Notes Specific to Real Estate Professionals: Rental activities, by nature, normally do not require significant day- to-day involvement, i.e. they are not time intensive. For many taxpayers using any kind of outside management, the only material participation test available is the 500 hour test- the other tests will not apply. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity.
Examination Techniques: Review W-2s and other non-passive activities. Does it seem likely that the taxpayer claiming to be a real estate professional could spend 500 hours on the activity in light of other employment obligations? Ask questions on taxpayer material participation activity time early in the examination. Establish time the taxpayer spends on all activities during the initial interview if possible. Determine the location of each activity. If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?
Tax Court: Despite the IRS’s ATG notes on passive activities, the Tax Court in Pohoksi v. Commissioner, Tax Court Memo 1998-17 implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a property management company. This is a satisfaction of test #2.
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
ATG Notes: Stated simply, if the taxpayer does most of the work, income or loss will be non-passive. The involvement in the activity of an employee or non-owner could cause the taxpayer to fail this test. There is no specific number of hours associated with this test. In addition, the term “substantially” is not defined in the regulations.
Tax Court: In Pohoski, the Tax Court noted that the taxpayer did not introduce evidence of the hours spent by a property management company. The Tax Court implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a third party (in this case a management company). Pohoski v. Commissioner, Tax Court Memo 1998-17 stated the second test was not satisfied when taxpayers failed “to put forth some indication of the actual time spent by” third-party non-owners in activities on the property.
WCG Notes: This test is critical for partial year rental property activities. If you buy a rental and place it into service on October 1, the hours in test #1 above and test #3 below are not pro-rated for the partial year. The hours threshold is strict.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
ATG Notes: If a taxpayer participates in an activity for more than 100 hours and no other individual participates more than the taxpayer (including any employee or non-owner), income or losses from the activity are non-passive.
Examination Techniques: Be alert to employees who are managing the activity, indicating the taxpayer deducting the losses may not be materially participating (particularly on Form 1040 Schedules C and F). When reviewing taxpayer hours, watch for “investor” activities (Internal Revenue Code Section 1.469-5T(f)(2)(ii)). The taxpayer must be involved in the activity’s day-to-day management or operations. Hours spent toward reviewing financial statements, preparing analysis for personal use, and monitoring the activity in a non-managerial capacity do not count.
4. The activity is a significant participation activity (SPA), and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
ATG Notes: The term significant participation activity is unique to Internal Revenue Code 1.469-5T. If the sum of the taxpayer’s time in all SPAs is more than 500 hours for the year, then income or losses from the businesses are non-passive and the taxpayer might be considered a real estate professional. For each SPA, the regulations require: The taxpayer to participate more than 100 hours during the year. The activity must be a business, i.e. it cannot be a rental or investment activity. The business must be a passive activity. Thus, if the taxpayer works more than 500 hours in the business, it is not a SPA as 500 hours is one of the qualifying tests for material participation. Similarly, if the taxpayer does most of the work in the business, it cannot be a SPA as Internal Revenue Code Section 1.469-5T(a)(2) holds that performing substantially all the work qualifies for material participation.
5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
ATG Notes: An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity.
Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.
6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
ATG Notes: None.
Examination Techniques: None.
Tax Court: As far as we can tell, this test has not been used in tax court involving real estate professionals and rental properties.
Some real estate investors and tax strategists have argued that operating rental properties is a personal service. We disagree. The personal services listed in this test are traditional service professions where you would have clients or patients. Of course an argument could be made that tenants are clients, but the one hiccup is the rental property itself. The personal service would not exist if it wasn’t for the building, therefore capital is a material income-producing factor (income comes from rents, rents come from tenants, tenants live in buildings, buildings require capital for acquisition).
Said in another way, the personal service is being spent on the building (maintenance, approving who gets to use it, recording transactions regarding the building, etc.) rather than on a person. Therefore it is not truly personal service. Personal service has the word person in it to boot! Also, doesn’t #6 look eerily similar to the rules in Section 199A qualified business income deduction.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
ATG Notes: The facts and circumstances test may apply if none of the other tests are met. This test does not apply unless the taxpayer worked more than 100 hours a year. Furthermore, the taxpayer’s time spent managing will not count if: Any person received compensation for managing the activity and any person spent more hours than the taxpayer managing the activity.
Examination Techniques: Taxpayers may argue the facts and circumstances test when they fail the others. However, due to the stringent limitations, few taxpayers can meet the facts and circumstances standard. If there is paid on-site management, the facts and circumstances test cannot be used.
If you owned an activity as a limited partner or member, you generally are not treated as materially participating in the activity. However, you are treated as materially participating in the activity if you met test #1, #5 or #6 described above. You can also see Chambers v. Commissioner, Tax Court Summary 2012-91 for some real snoozer material.
Grouping Rental Activities Together
Do I need to group my rental activities together? Yes. Otherwise you will need to prove material participation for each property. That’s tough. Three rentals becomes over 40 hours a week. The election is simply a statement that is attached to your tax return. And under IRS Revenue Procedure 2010-13, you can make the election retroactively (typically requires amending a tax return just for the election). To recap a bit-
- You need to prove real estate professional (REP) status first.
- Next, you need to prove material participation in each of the rental property activities, unless grouped together as a single activity.
Disallowed losses prior to grouping your rental activities together are suspended if you also claim the real estate professional designation with material participation. Unbundling is required during a sale of a property to deduct the disallowed and suspended losses.
Grouping also helps taxpayers obtain the 10% interest requirement in the activity for active participation.
Lastly, with the new Medicare surcharges (Net Investment Income Tax) being attached to passive incomes, grouping your activities into one activity while materially participating as a real estate professional allows you to sidestep this 3.8% tax. In the past, the real estate professional designation was only useful if you had rental losses… now it is useful if you have rental profits.
