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Will Setting up a Property Management Company Help Me Materially Participate?

Will Setting up a Property Management Company Help Me Materially Participate?

Welcome to Tax Smart Daily, episode number 13, a daily video series for real estate investors to learn about taxes and stay out of trouble. I’m Brandon Hall. Before we get started, I invite you to join our Tax Smart newsletter and our Tax Smart Facebook group. Links to both of these are in the description of this video. Additionally, if you have any questions or if anything resonates with you, comment on this YouTube video with the timestamp. Let me know what you’re thinking and what you need clarity on, and I’ll definitely jump in and help you out. I love interacting with the community—it’s my oxygen. And lastly, mash that subscribe button. I don’t want you to miss any new videos that we drop, not only with this series but everything else that we’re doing on YouTube as well.

Today’s Topic

It’s a question, and the question goes, “My CPA said that I should set up a property management company in order to substantiate the material participation requirements to make my rental activities non-passive. Is that true or false?” Now, before we get into the meat of this question, we should probably back up a little bit, zoom out, and explain what’s going on. Section 469 of the code says that all rental activities are passive by default unless you qualify as a real estate professional. Now, passive activities can only offset passive income, so passive losses from passive activities can only offset passive income. That means my rental losses, since they’re passive, can only offset other passive income that I’m generating. Well, the problem is that my W-2 job, my business income, my stock sales, my dividends, my interest—that is all considered not passive or non-passive for the purposes of Section 469. This means that my rental losses cannot offset any of that income, and often this comes as a shock to new landlords.

They go out and buy a million-dollar apartment complex, a million-dollar office space, a $500,000 single-family home—whatever it is they’re buying something to rent out. Then they look at the depreciation, sometimes they get bonus depreciation, and they see this big tax loss at the end of the day and they get excited because they think, “Cool, now I’m going to be able to use that tax loss to offset my W-2, my business income, my stocks, gain on stock sale, dividends, interest—all that type of income.” But you can’t use your rental losses to offset that type of income because that type of income’s non-passive.

Real Estate Professional Status

The only way that you can get your rental losses to offset that type of income is to qualify as a Real Estate Professional, re-characterize the rental losses from a passive activity to a non-passive activity. And the way to do that is to qualify as a real estate professional and materially participate in the rental activity. So first, you must qualify as a real estate professional: spend 750 hours in real property trades or businesses, and you have to spend more time in those real property trades or businesses than you do anywhere else—those are the two statutory tests to qualify as a real estate professional. Once you qualify as a real estate professional, you then have to demonstrate that you materially participated in your rental activities. If you can qualify as a real estate professional and if you can demonstrate that you materially participated in your rental activities, then your rental will now be considered non-passive, and any loss generated from the rental will be able to offset any type of income that you have—it’s not going to be trapped in that passive bucket.

Passive Losses

We’ve talked about passive loss rules on some other daily Tax Smart Daily episodes. I highly recommend you go check those out, especially when we talk about suspended passive losses. Because if you can’t use that passive loss—like if there’s no passive income to offset and you’re not a real estate professional and you don’t qualify for the $25,000 loss allowance—then that loss just gets suspended and carried forward. You don’t lose it; you will be able to use it at some future point, just not today. But we want to use it today because the Time Value of Money theory says a dollar today is worth more than a dollar tomorrow. So I want to capitalize on everything that I can today, take all my benefits today, if possible. And I should say, in general, right—if you’re in a very low tax bracket today and you’re going to be in a really high tax bracket next year, then maybe that’s not the best strategy for you, but in general, I want to take those losses today. So I want to qualify as a real estate professional and I want to materially participate in my rental activities.

Material Participation 

So now let’s get back to the meat of this question. It says, “My CPA says that I need to set up a property management company to help substantiate material participation in my rental activities.” And that’s not true. It could help if you’re going to start a property management company, because when I mean that, I mean like you’re going to go out and offer services to third-party providers or third-party tenants and landlords. The reason that I say that is property management is one of the 11 real property trades or businesses that counts towards the 750 hour test and the more than half your time test. So if you’re going to go and set up a property management company to then actually make money at, run an actual legitimate business with, then it can help you for the purposes of the real estate professional status test. It’s still not going to help you for the rentals unless you’re self-managing your rentals, but at that point, you don’t need a property management company because you would just self-manage your rentals.

Material participation is all about the time that you spend in the activity; it’s not about the form. And you have to be really careful when it comes to form because the IRS has a doctrine that says they can execute or they can look at substance over form. So if I simply go set up a property management company and then I say somehow that that makes me materially participating in the activity, that’s the form right—the entity structure is the form. Well, the IRS is going to look at substance over form. So they’re going to peel back the layers of this onion and they’re going to ask, “But what did you actually do? What’s the actual substance, the actual activity?” That’s what they’re wanting to know, and they’ll figure out that this property management company was set up as a shell company to charge self-rental income, um and it’s just not going to help you out.

Summary

So if you’re setting up a property management company for your own rentals, and that was kind of the context of this question, then it’s not going to help you for the purposes of material participation. If you’re setting up a property management company because you want to legitimately get into the property management business, well now you’re providing these services, you’re running a real property trader business, you’re providing these services to third parties. Now all that time is going to count towards the real estate professional status test.

So again, we have real estate professional status tests and then we have material participation tests—they’re all based on hours, substance over form, what did you actually do. To hit a real estate professional, I don’t have to just manage my rentals—that’s where everybody gets confused. I can run a property management business, I can be a real estate agent or I can be a broker, I can be a flipper, I can be a wholesaler, I can be a builder. And if I hit 750 hours in those activities and more time in those activities than I spend anywhere else, then I’m a real estate professional. But then I have to ask, how do I materially participate in my rental activities? And setting up a property management company is not going to help you materially participate in your own rental activities because you could do it without the property management company. It’s just all about the time that you spend managing your rentals—that’s material participation for your rental activities.
Listen in to learn:

  • How to obtain the real estate professional status
  • How setting up a property management company counts as material participation
  • Why forming a property management company is not going to help you materially participate in your own rental activities

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