Real Estate Professional
A key real estate issue that appears over and over in IRS Tax Audits is what to do about real estate losses. In other words, can the taxpayer fully deduct such losses? The answer to this question, like most things legal, is Yes and No.
Investors who qualify as real estate professionals can elect not to treat rental activities in which they “materially participate” as passive activities. This lets them deduct their full loss from the activity, not just their first $25,000, regardless of their overall adjusted gross income.
Investors meet the material participation requirement for a particular activity by participating throughout the year on a regular, continuous, and substantial basis. They demonstrate this by meeting one of the following seven tests:
| 1. | They participate in the activity for more than 500 hours during such year. |
| 2. | Their 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. | They participate in the activity for more than 100 hours during the taxable year, and their 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 for the taxable year, and their aggregate participation in all significant participation activities during such year exceeds 500 hours. |
| 5. | They materially participated in the activity 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 and they materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year. |
| 7. | Based on all of the facts and circumstances, they participate in the activity on a regular, continuous, and substantial basis during such year. |
Investors who materially participate in one or more activities qualify as real estate professionals if they satisfy two further tests:
| 1. | They spend at least 750 hours per year in real property trades or businesses in which they materially participate. Qualifying real property trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Personal services performed as an employee are not treated as performed in real property trades or businesses unless the employee owns 5% or more of the employer entity. (This means 5% of a corporation’s outstanding stock or voting interest, or 5% of a partnership’s capital or profit interest.) |
| 2. | They spend more than half of their working time on real estate activities in which they materially participate. |
Qualifying real estate professionals should keep a contemporaneous business diary or appointment book to verify their service. While Treasury Regulations don’t prescribe specific recordkeeping requirements, they don’t allow a post-event “ballpark guesstimate.” Real estate professionals complete the “Reconciliation for Real Estate Professionals” in Part V of Schedule E to identify themselves as such.
Material participation is defined separately for each activity. However, investors can elect to treat all of their real estate activities as a single activity. This makes sense if no single activity meets the 750-hour test to qualify for “real estate professional” status, or if the real estate professional is a passive investor (not meeting the material participation test) in an activity generating losses that would be disallowed if the professional chose not to aggregate that activity with their others. Taxpayers make the election by filing a statement with their original, timely-filed return for any taxable year in which they qualify. The election is binding for the year made and all future years (even if they no longer would qualify to make the election) and can be revoked only if there is a “material change” in the investor’s facts and circumstances.
Investors whose income is too high to claim the rental real estate loss allowance and who don’t qualify as real estate professionals can buy passive income generators, or “PIGs,” for tax-free income to be “soaked up” by real estate losses. These are generally limited partnership interests generating taxable income from real estate, oil & gas, equipment leasing, and similar sources treated as passive activities.