A taxpayer can overcome the presumption that all rental activities are passive if the taxpayer qualifies as a real estate professional by satisfying the two quantitative tests of Sec. 469(c)(7)(B):
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
- 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.
There are 11 types of real property trades or businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
Qualifying as a real estate professional allows the taxpayer to overcome the presumption that all rental activities are passive. Why repeat the first line of this article? Because qualifying as a real estate professional alone does not mean that the rental activities are non-passive. There is a second step: material participation.
Tests for Material Participation
To materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis. The seven tests that measure this are:
- The individual participates in the activity for more than 500 hours during the tax year.
- The individual’s participation in the activity for the tax 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 the year;
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax 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 the year;
- The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
- The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
- The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
Additional Notes About Material Participation
Hours spent as an employee are not counted unless the employee is a 5% owner in the company. Additionally, “investor” hours do not count toward material participation hours – such hours include: studying and reviewing financial statements, searching for new properties, education, preparing summaries of the finances or operations, or managing the finances of an activity in a nonmanagerial capacity.
If the taxpayer holds an interest in a real property trade or business through a limited partnership interest, the taxpayer may establish material participation only by satisfying the first, fifth, or sixth tests of the seven tests from above
A married taxpayer is required to count any hours performed by his or her spouse, even if the spouse does not own an interest in the business or if no joint return is filed. However, the spouse’s hours only count toward material participation and not toward the real estate professional status.
The taxpayer must materially participate in each passive activity separately. This means if you own 5 rentals, you must show you materially participated in each individual rental activity which can be extremely difficult to do. To get around this, you can make a grouping election under IRS Regs. Sec. 1.469-9(g) but it is highly recommended you speak to a CPA prior to this as the election can have negative long-term consequences.
Benefits of Qualifying as a Real Estate Professional
The benefits of qualifying as a real estate professional are that you can deduct passive losses in an unlimited amount and avoid the Net Investment Income Tax. This will significantly reduce a landlord's tax bill.
For example: Chris is a real estate agent and spends 1,200 hours representing clients in purchase and sale transactions. As a result, Chris qualifies as a real estate professional for tax purposes. Chris also has one rental property that produced a $10,000 loss that Chris cannot utilize because he earned over $150,000 during the year. Qualifying as a real estate professional is only step #1 for Chris as he must also demonstrate that he materially participated in his rental activity.
Luckily, Chris maintains great records and was able to prove he materially participated in his rental activity because he spent 500 hours managing the rental, it’s contractors and the rehab. As a result, Chris can deduct the $10,000 passive loss against his ordinary income.
It’s important to note that you must keep contemporaneous records and those records need to be absolutely bulletproof to substantiate your real estate professional status claim.