Brandon Hall and Thomas Castelli break down Section 469 (the real estate professional status), the history of Section 469, and why it matters to real estate investors. This is the first episode in a series of episodes designed to set the record straight and demystify some of the complexities of this area of the tax code and address misinformation and misconceptions.
Section 469/Passive Loss Section/Real Estate Professional Status Subject Matter
- REPS 01: The History of § 469 (Passive Activity Losses) & Why it Matters to Real Estate Investors
- REPS 02: How You Can Offset W-2 & Active Business Income by Qualifying as a Real Estate Professional
- REPS 03: Strategies to Qualify as a Real Estate Professional & Busting the Myths of the Internet
- REPS 04: How the IRS Audits The Real Estate Professional Status & What to Do to Protect Yourself
Before Section 469, real estate investors would take their real estate losses and offset against their wages earned. This would allow high income earners to directly reduce their taxable income through accelerated depreciation a noncash adjustments that create losses. This was creating a tax shelter.
With rental real estate, it is a passive activity, but the losses could previously be taken against active/ordinary income. Somewhere along the line, this was deemed unfair, so Section 469 was instated in the Tax Reform Act of 1986.
Thus, a big portion of achieving this real estate professional status is material participation. Additional requirements now exist to take these losses against active/ordinary income and avoid the default treatment of passive income.
"If you're simply providing capital, if you're not really actively participating, should you really receive such a big tax benefit for just providing capital? That's what they target in Section 469 in the Tax Reform Act of 1986. Section 469 creates two buckets of income - passive and nonpassive income."
A trade or business which you do not materially participate in is a passive business. Additionally, all rental real estate is automatically treated as passive, unless you qualify as a real estate professional. With this status, the losses can be taken against other nonpassive income, such as W2 income, wages from an active small business, and capital gains, interest, and dividends earned, such as the sale of stock.
"It's not about using rental income to offset rental losses. It's about using passive losses to offset passive income. This is any sort of passive income from any source."
The loophole, before 1986, was that investing in rental real estate was an automatic major reduction in tax liability. The Tax Reform Act closed this loophole. The real estate professional status is not a loophole - it's taking you back to the pre-1986 treatment of passive real estate investing.
From 1986 - 1994, all rental real estate was passive. In 1994, the real estate professional status was introduced. If you were full-time in real estate, you're taking the capital you earn, and investing it into rental real estate to generate rental losses. This was added for individuals who were full-time in real estate, such as flippers, developers, and property managers, to use their real estate losses against real estate income.
"The real estate professional status was not added to help the high income earners invest in real estate and use rental real estate to offset their income."
"Every dollar that you earn goes into one of two buckets. It's either passive or nonpassive. If it goes into the passive income or passive loss bucket, it's stuck there, you can't move it over into the nonpassive bucket. When we talk about rental losses, and it's in the passive bucket, and I don't have passive income to offset that loss, that loss becomes suspended and carries forward forever [until you generate passive income to use the loss]. If you qualify as a real estate professional and show you materially participated in the rental activity, the loss would be reclassified and move into the nonpassive bucket and can be used to offset other nonpassive income."
Stay tuned for Part 2, where Brandon and Thomas discuss the statutory tests to qualify as a real estate professional.