Benefits and Drawbacks for Rental Real Estate Professionals

The main benefit of electing to be a rental real estate professional is being able to treat otherwise passive rental real estate activities as nonpassive; thus, losses can offset wages, interest and other nonpassive income. This is only available to eligible real estate professionals who materially participate in a rental real estate activity. On the other hand, the election may be disadvantageous if the activity generates income and the taxpayer has other passive activity losses; the income cannot be offset by the passive losses.

Real Estate Professional Eligibility

Under Sec. 469(c)(7)(B), an individual is an eligible rental real estate professional for any tax year if:

1. More than 50% of the personal services the taxpayer performed in all trades or businesses during the tax year were performed in real property trades or businesses in which he or she materially participates; and

2. During the tax year, the taxpayer performed more than 750 hours of services in real property trades or businesses in which he or she materially participates.

Material Participation

Any work performed in an activity in which the taxpayer owns an interest is generally deemed participation. Un-der Sec. 469(h) and Temp. Regs. Sec. 1.469-5T(a), an individual materially participates in an activity if he or she meets any of the following tests:

1. The taxpayer participates in the activity for more than 500 hours during the year.

2. The participation constitutes substantially all of the participation by all individuals in the activity (including nonowners).

3. The taxpayers participation is more than 100 hours during the year, and no other individual participates more hours than the taxpayer (including nonowners).

4. The activity is a significant participation activity, and the taxpayers annual participation in all such activities is more than 500 hours during the year. (A significant participation activity is generally a trade or business activity (other than a rental activity) in which the taxpayer participates, but not materially, for more than 100 hours during the year (under any of the material participation tests other than this test), according to Temp. Regs. Sec. 1.469-5T(c).)

5. The taxpayer materially participates in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years.

6. If the activity is personal service, the taxpayer materially participates for any three tax years preceding the current tax year (whether or not consecutive).

7. Based on all the facts and circumstances, the taxpayer participates on a regular, continuous and substantial basis during the year.

According to Sec. 469(c)(7)s flush language, when determining material participation, a taxpayer may elect to treat all interests in rental real estate activities as a single activity (discussed below), enabling him or her to more easily meet one of the tests. However, for material participation purposes, a rental real estate activity may not be combined with a nonrental real estate activity. Unless an election is made to treat all interests in rental real estate activities as a single activity, the taxpayer must treat each interest separately.

Although under Temp. Regs. Sec. 1.469-4(d)(1)(i), rental and nonrental real estate activities generally cannot be grouped when determining material participation, they can be combined if the grouping constitutes an appropriate economic unit and (1) the rental activity is insubstantial in relation to the nonrental activity or (2) each owner in the nonrental activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity involving rental of items to the nonrental activity may be grouped with the nonrental activity. A grouping of this type is not allowed when trying to meet the real estate professional rules noted above.

Spousal participation: When determining eligibility for the real estate professional rules, there are special rules to account for services performed by a spouse. For a husband and wife, the 50% and 750-hour tests are satisfied if only one spouse satisfies the tests; see Sec. 469(c)(B), flush language.  However, this is not the case when determining material participation in an activityeach spouses participation is combined. Thus, one spouses participation is deemed participation for the other spouse; see Sec. 469(h)(5).

Example 1: M and D are married and file jointly for 2005. M owns 70% of ABC Partners, a general partnership that rents commercial real estate properties. He spends about 60% of his working hours on ABC activities (approximately 675 hours per year). He also spends 150 hours working for a charitable foundation. M owns a 10% interest in XYZ Condominiums, a general partnership that owns and leases condominiums. He spends about 95 hours per year performing services for XYZ. D works part-time (15 hours per week, or 780 hours per year) as a manager for XYZ (which also has full-time employees). During 2005, M is allocated a $20,000 rental loss from XYZ. Can M and D deduct this loss on their 2005 return as a nonpassive loss?

First, M must determine whether he qualifies as a real estate professional. He meets the two real estate professional rulesspending more than 50% of his total trade or business (defined below) service hours and more than 750 hours working in real estate trades or businesses. He worked 675 hours renting real estate properties and 95 hours leasing condominiums, a total of 770 hours. M can include the 95 hours he spent working for XYZ because, even though he did not materially participate in that activity, he is deemed to materially participate after considering the 780 hours D spent on the activity.

Second, to treat the $20,000 rental loss from XYZ as nonpassive, M must have materially participated in the activity. As mentioned above, even though he did not individually materially participate in XYZ, he can combine his participation with Ds. Together, they participated for 875 hours in XYZ (780 + 95), which qualifies as material participation.

Thus, M and D can deduct the $20,000 rental loss from XYZ on their 2005 return, because M qualifies as a real estate professional and, together, he and D materially participated in XYZ.

Real Property Trades or Businesses

According to Sec. 469(c)(7)(C), a real property trade or business broadly includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. To be eligible for the real estate professional rules, a taxpayer must materially participate in real property trades or businesses, rather than in business activities involving real estate transactions. This suggests that the benefits of these rules may be unavailable to individuals who are only peripherally involved in real property trades and businesses.

In some instances, a taxpayer may need to elect to treat all rental real estate interests as a single activity. If the taxpayer participates in multiple rental real estate interests and has another profession that requires substantial time, it may be impossiblewithout an electionto satisfy the two sets of criteria noted above.

Example 2: B is a general partner in MV Partners, which was formed to develop and rent office buildings. He is the sole general partner, but employs a full-time staff. During 2005, he spent approximately 1,750 hours on development activity and 450 hours on rental activity. His share of the loss from the rental activity was $15,000. B also owns three small leasing companies; each one has its own manager. He spends approximately 85 hours per year managing each company. Losses incurred in each of the companies for 2005 were $4,000. B performs no other personal services.

B qualifies as a rental real estate professional, regardless of whether he elects to treat all of his real estate activities as a single activity, because his participation in the development activity meets both the 750-hour and 50% tests. However, without the election, B does not meet any of the seven tests that determine material participation. Thus, all of the rental losses remain passive. If B were to elect to treat all rental interests as a single activity, he could combine all of the hours he spent participating in each activity (450 hours + (85 hours 3 leasing companies) = 705), which would qualify as material participation. With the election, B would be able to treat the $27,000 combined loss as passive ($15,000 + ($4,000 3 leasing companies)).

Other Considerations

There are a few situations that affect whether taxpayers should make the real estate professional election. For example, suspended losses from years before the real estate professional rules apply to the taxpayer are treated as losses from a former passive activity; see Sec. 469(f) and (g). Any such losses remaining when the entire activity is disposed of in a fully taxable transaction are deductible in the disposition year. Thus, suspended losses cannot be deducted until all the activity has been disposed of, or other passive income is generated.

1. If taxpayers have net income from rental real estate activities in which they do not materially participate, retaining passive status for those activities will allow passive income to offset future passive losses.

2. When taxpayers hold rental real estate activities via passthrough entities, they are bound by how the entity groups the activities, if they hold less than a 50% interest. However, if their interest is greater than 50%, each rental real estate interest held by the entity is treated as a separate interest of the taxpayer, regardless of how the entity groups the interests. In either case, if taxpayers elect to combine rental real estate activities, the election includes those held through passthrough entities as well.

3. Taxpayers who actively participate in rental real estate activities can offset against nonpassive income up to $25,000 of otherwise passive rental real estate losses from such activities, under Sec. 469(i). The $25,000 offset is reduced by 50% of the amount by which a taxpayers modified adjusted gross income exceeds $100,000.

Conclusion

Every angle of the real estate professional rules should be closely analyzed before deciding whether to elect to be a real estate professional. The election can be made in any year the special real estate professional rules apply. However, once the election is made, it is irrevocable, unless there is a material change in the taxpayers facts and circumstances.

From Kelli Foley, and Russ Matthys, CPA, South Bend, IN