Defining Real Estate Professional for PAL Purposes

In 1993, enacted legislation sought to mitigate some inequities resulting from the passive activity loss (PAL) limit rules enacted in the mid-1980s. Simply put, a real estate professional can deduct certain rental real estate activity losses against all categories of income. However, the legislative relief has been narrowly applied in 1995 regulations and recent court cases. Only activities in which a taxpayer materially participates determine real estate professional status; this has proven to be a trap.

Sec. 469(c)(7)(B) defines a real estate professional as a taxpayer who (1) spends more than 750 hours and (2) performs more than one-half of his or her personal services during the tax year in real property trades or businesses in which he or she materially participates. Sec. 469(h) and Temp. Regs. Sec. 1.469-5T(a) apply in determining whether the material participation standard is met.

Tests

In determining whether a taxpayer meets the two time requirements in Sec. 469(c)(7)(B), only real estate businesses in which the taxpayer materially participates are taken into account. If the two tests are met, the taxpayer is a real estate professional; Sec. 469(c)(7) exempts his or her rental activities from Sec. 469(c)(2), so they are not passive per se. The Temp. Regs. Sec. 1.469-5T tests are then applied to the taxpayers rental activities. If these activities meet any of the temporary regulations material participation tests, the losses therefrom are not PALs.

Rental real estate cannot be aggregated with nonrental real estate operations; thus, if X spends 600 hours developing real estate and 200 hours on each of his four rental real estate activities, he is not a real estate professional. If a taxpayer spends 750 hours and more than one-half of his or her time on development, the taxpayer may be a real estate professional, but the rental losses may not be deductible if he or she does not materially participate in each of the rental activities.

This result was illustrated in Karl Jahina, TC Summ. Op. 2002-150, in which the taxpayer had five rental properties. The court stated, Jahina must qualify as a real estate professional with respect to each property separately in order to avoid a determination that the rental activities were per se passive under section 469(c)(2). Thus, the Sec. 469(c)(7)(B) two-part test must be applied separately to each rental real estate activity.

Aggregation

An aggregation election in Sec. 469(c)(7)(A), flush language, allows a taxpayer to treat all rental real estate as one activity. Thus, in the above example, X would treat all rental real estate as one activity when applying Sec. 469(c)(7)(B)s two-part test. The 800 hours spent on rental real estate (four properties at 200 hours each) may qualify X as a real estate professional if that time is more than one-half of Xs personal service time for the year. The election can also affect the Sec. 469(g) complete-disposition rules.

Professional status needs to be determined each year. A flowchart to apply Sec. 469(c)(7) appears in Exhibit 1.

From Jeff Albrecht, CPA, CSEP, Sol Schwartz & Associates, P.C., San Antonio, TX