The Health Care and Education Reconciliation Act of 2010 (Reconciliation Act), P.L. 111-152, imposes an additional 3.8% tax on net investment income, which includes income from common financial investments and from passive trade or business activities, including real estate rentals.
Starting in 2013, this tax raises the stakes for taxpayers pursuing real estate activities, particularly rentals. It increases potential financial downsides to pursuing passive activities or activities that the IRS may deem passive under Sec. 469. If the passive activity operates at a net loss for the year, the losses in excess of income are generally not currently deductible (deferred), and if the activity operates at a net gain, the profit can be hit with the additional 3.8% tax. Consequently, meeting the tests for qualifying as a real estate professional and material participation can be doubly important.
Under Sec. 1411, enacted by the Reconciliation Act, the threshold modified adjusted gross income (MAGI) amount for the 3.8% tax to apply is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing separately, and $200,000 in any other case. MAGI is adjusted gross income increased by foreign earned income excluded under Sec. 911(a), which is defined as net of the deductions and exclusions disallowed with respect to the foreign earned income.
Net investment income is the sum of the excess of:
- Gross income from interest, dividends, annuities, royalties, and rents, other than such income that is derived in the ordinary course of a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities;
- Other gross income derived from a trade or business that is a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities; and
- Net gain (taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities; over
- Allowable deductions allocable to such gross income or net gain (Sec. 1411(c)(1)).
Passive activities under Sec. 469 generating net investment income include, notably, real estate rental activities, except for real estate rental activities of materially participating real estate professionals, as described below. Therefore, it is now all the more important for taxpayers who meet the threshold amount who are real estate professionals to be able to document and support their material participation in real estate activity, not only to preserve their ability to recognize losses from the activity but also to limit their net investment income tax liability.
PASSIVE ACTIVITY LOSSES
Under Sec. 469(a), a passive activity loss of an individual for a tax year is generally not allowed as a deduction for the year. For this purpose, the passive activity loss is generally the amount by which the passive activity deductions for the tax year exceed the passive activity gross income for the year (Sec. 469(d)(1) and Temp. Regs. Sec. 1.469-2T(b)(1)). Sec. 469(c) defines “passive activity” as any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate and any rental activity without regard to whether the taxpayer materially participates in the activity (but see discussion of material participation by a real estate professional, below).
Generally, disallowed passive losses may be carried forward to the next tax year (Sec. 469(b)). However, if the activity continues to be passive in future years, losses are in effect carried forward until the underlying activity is disposed of (Sec. 469(g)). In the real world, this translates to the losses accumulating until the property is sold.
RENTAL REAL ESTATE ACTIVITIES
Although rental real estate activities are per se passive, they may nonetheless avoid the passive loss limitations if the taxpayer (1) qualifies as a real estate professional and (2) materially participates in each rental activity. Under Sec. 469(c)(7)(B), a taxpayer is a real estate professional if (1) more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) 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. In a joint return, these requirements are satisfied if either spouse separately satisfies them (Sec. 469(c)(7)(B)).
The best way to explain and simplify this complicated Code section is to visualize two circles, one large and one small (see Exhibit 1). The smaller circle is completely within the larger circle. The larger circle represents all the taxpayer's activity relating to the real estate profession. All activities (hours) that are spent on real estate that fall within the larger circle count toward the two tests mentioned above, both toward the 750 hours on real-estate-related activities and toward the more-than-50% test; in other words, the taxpayer must spend more time on real-estate-related activities than on non-real-estate-related activities.
The second, smaller circle represents material participation hours on particular properties owned by the taxpayer. As explained later, the tests for material participation relating to the properties owned (since they fall within both the smaller circle and the larger one) count toward the “real estate professional tests,” above, as well. The hours spent on particular properties also count toward the specific property-by-property material participation tests.
However, activities relating to real estate in general (in the larger circle but not in the smaller one) do not count toward the specific property material participation tests and only count toward the real estate professional tests. An example would be a taxpayer who is searching for additional replacement property to acquire in a Sec. 1031 exchange. The taxpayer is certainly engaged in a real-estate-related activity, and his or her hours in this regard count toward being a real estate professional. But, because no property is actually owned related to the activity, no material participation hours are acquired relating to a specific activity, as explained in greater detail below.
QUALIFYING AS A REAL ESTATE PROFESSIONAL
More Than One-Half of Personal Services in Real Property Trades
As a practical matter, it is exceedingly difficult for taxpayers to prove to the IRS’s satisfaction that they meet the real estate professional threshold if they are otherwise employed in an unrelated occupation.
The IRS typically uses this first factor (the bigger circle) to exclude taxpayers with non-real-property-related full-time occupations. An examiner assumes that 40- or 50-hour-a-week wage earners would have to spend more than an additional 40- or 50-plus hours a week in a real property trade or business. Even if the taxpayer does not work full time in an unrelated occupation, an unrelated part-time occupation can still make it difficult for him or her to meet the 50% requirement.
More Than 750 Hours Spent in a Real Property Trade or Business
The second requirement of proving more than 750 hours were spent in the tax year materially participating in real property trades or businesses likewise presents a substantial issue of proof. In DeGuzman, 147 F. Supp. 2d 274 (D.N.J. 2001), the taxpayer husband failed to meet the 750-hour requirement when a portion of the hours were spent cleaning, shoveling snow, and maintaining his wife’s leased office space, because he was basically just being a nice husband rather than participating in a trade or business. Hours spent on call, available to attend to rentals should the need arise, do not count toward the 750-hour requirement (see Moss, 135 T.C. 365 (2010)).
Furthermore, without a detailed, contemporaneous log, the Tax Court has repeatedly found reconstructed logs and taxpayer testimony to be inadequate proof of the number of hours (see, e.g., Harnett, T.C. Memo. 2011-191). The Treasury regulations do not specifically require a contemporaneous log and indicate that a “narrative summary” by the taxpayer can suffice (Temp. Regs. Sec. 1.469-5T(f)). In practical application, however, the IRS regularly dismisses a narrative summary as self-serving and is more apt to accept a contemporaneously created log that is cross-referenced to objective substantiation.
A good example of an acceptable log is one that references, for example, “meetings with the plumber,” and the hours indicated are cross-referenced to a calendar entry, an invoice from the plumber with that date, and telephone records of calls made to the plumber’s number.
If the two threshold real estate professional factors are satisfied, each rental activity will nonetheless be treated as a passive activity under Sec. 469(c)(1), unless the taxpayer materially participated in each rental activity (evaluated separately) (Regs. Sec. 1.469-9(e)(1)), unless the taxpayer elects to treat all interests in rental real estate as a single rental real estate activity. The hours spent on material participation on specific properties is the theoretical “smaller circle” mentioned above. Every hour spent by the taxpayer that counts toward material participation with respect to the actual properties owned by the taxpayer also counts toward the hours required to be a qualified real estate professional (as they fall within both circles).
In other words, in determining a taxpayer’s material participation in a rental real estate activity, the rental real estate activity cannot be grouped with any other activity of the taxpayer (Regs. Sec. 1.469-9(e)(3)(i)). For instance, a taxpayer’s activities as a real estate agent assisting clients with buying and selling homes and maintaining bank-owned properties are separate from his or her activity as the owner of rental real estate for the purpose of determining whether he or she passes the material participation tests with respect to the rental real estate (see Hoskins, T.C. Memo. 2013-36). Likewise, in Perez, T.C. Memo. 2010-232, the taxpayer qualified as a real estate professional, but she did not actively participate with regard to her three rentals. Her activity as a real estate agent and loan broker was separate and irrelevant to whether she materially participated in the “smaller circle” of the rental real estate activities.
A taxpayer can establish material participation by satisfying any one of seven tests provided in Temp. Regs. Sec. 1.469-5T(a): (1) The individual participates in the activity for more than 500 hours during such year; (2) 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; (3) the individual participates in the activity for more than 100 hours during the tax year, and that 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 in the activity) for the year; (4) participation in the activity is significant (exceeds 100 hours during the year), and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours; (5) the individual materially participated in the activity for any five tax years (whether or not consecutive) during the immediately preceding 10 tax years; (6) the activity is a personal service activity (performing personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor), and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or (7) based on all the facts and circumstances (including specified ones in Temp. Regs. Sec. 1.469-5T(b)), the individual participated in the activity on a regular, continuous, and substantial basis during the year.
Work done by an individual in the capacity of an investor in an activity is not generally treated as participation in the activity (Temp. Regs. Sec. 1.469-5T(f)(2)(ii)(A)). The IRS typically considers activities of an investor for this purpose to include studying and reviewing financial statements or reports on operations of the activity, preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use, and monitoring the finances or operations of the activity in a nonmanagerial capacity (Temp. Regs. Sec. 1.469-5T(f)(2)(ii)(B)). In Lapid, T.C. Memo. 2004-222, the Tax Court found that reviewing financial statements and reports on operations from a management company was time spent in the taxpayer’s capacity as an investor, and thus they did not count toward material participation hours.
In addition, work is not treated as material participation if it is not of a type customarily done by an owner of such activity and if one of the principal purposes for performing such work is to avoid the passive activity limitations of Sec. 469. If the taxpayer uses the services of a management company and the taxpayer’s only activity is reading reports from the management company, that is an investor type of activity and is therefore passive. On the other hand, if the taxpayer is managing the property himself or herself and generating the reports for an accountant to put on a tax return, this should more likely count toward material participation.
To prove material participation, taxpayers face an uphill battle when their rental real estate activity is out of state or when a management company is involved. In Madler, T.C. Memo. 1998-112, the Tax Court found that the taxpayers failed to show that they, rather than the third-party management company they hired, materially participated in their real property rental activity. See also Koenig, T.C. Memo. 1998-215, finding real estate losses were passive when the taxpayer managed one rental property but hired a management company for four other rental properties.
When rental real estate is out of state, the IRS highly scrutinizes claims of material participation because it appears unrealistic to an examiner that taxpayers can do much on a property 2,000 miles from their home, for instance. In a rare taxpayer victory involving both of these issues, taxpayers were able to deduct the losses from one of their two out-of-state Hawaiian condos, without the passive loss limitations (Pohoski, T.C. Memo. 1998-17).
The key to overcoming the IRS’s bias against out-of-state property owners is to thoroughly document the tasks performed on the properties managed, with as much objective and as little subjective documentation as possible. A New York taxpayer managing her Florida rentals spent most of her working hours on the telephone with contractors, tenants, accountants, etc., and was able to convince the IRS that she was managing her properties from her base in New York. This was documented with telephone records, affidavits from the vendors, travel records, invoices, and substantiation notebooks, to the point that the IRS capitulated in the matter before trial (Hendren, No. 28245-07 (Tax Ct., settlement entered 3/2/11)).
ELECTION TO TREAT ALL REAL ESTATE INTERESTS AS A SINGLE ACTIVITY
As mentioned above, once a taxpayer qualifies as a real estate professional, his or her material participation is determined separately with respect to each rental property unless he or she elects to treat all interests in rental real estate as a single rental real estate activity (Sec. 469(c)(7)(A); Regs. Secs. 1.469-9(e)(1) and 1.469-9(g); see also Bailey, T.C. Memo. 2001-296). To make this election, the taxpayer files a statement with his or her original income tax return (see Regs. Sec. 1.469-9(g)(3)).
Once the election is made, it is binding for the tax year in which it is made and, unless duly revoked by the taxpayer, for all future years in which the taxpayer is a real estate professional, even if there are intervening years in which he or she is not a real estate professional. If a taxpayer failed to file an election to treat all interests in rental real estate as a single rental real estate activity with the original income tax return, Rev. Proc. 2011-34 allows the late filing of an election with an amended income tax return, provided several criteria are satisfied.
DISTINGUISHING RENTAL REAL ESTATE ACTIVITIES
In evaluating material participation, it is important to distinguish the properties that qualify as rental real estate from those that do not. In other words, if an election to treat “all as one” is made, only those hours spent with regard to properties that properly qualify as rental real estate count toward the annual hours of material participation requirements (Temp. Regs. Sec. 1.469-1T(e)(3); see also Hoskins, T.C. Memo. 2013-36, and Bailey, T.C. Memo. 2001-296).
Residential rental property that is rented, on average, for seven days or less at a time is not considered a rental activity for purposes of Sec. 469(c) (“vacation rentals”) (see Temp. Regs. Sec. 1.469-1T(e)(3) and Lapid, T.C. Memo. 2004-222). With vacation rentals excluded from rental activities within the meaning of Sec. 469(c), the real estate professional test is not a prerequisite, but material participation is still required to avoid the passive loss rules (see Chapin, T.C. Memo. 1996-56 (finding that the taxpayers did not materially participate when they had rental agents to handle the day-to-day operations); also Mordkin, T.C. Memo. 1996-187).
RECOMMENDATIONS FOR WITHSTANDING IRS SCRUTINY
The general rule is that taxpayers must substantiate amounts claimed as deductions by maintaining the records necessary to establish that they are entitled to the deduction (Sec. 6001; Regs. Sec. 1.6001-1(a)). With respect to the evidence that may be used to establish hours of participation, Temp. Regs. Sec. 1.469-5T(f)(4) provides:
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
As a practical matter, the best advice a tax professional can give a client who is claiming to be a real estate professional and/or claiming material participation is to strongly encourage the client to maintain a contemporaneous log detailing hours spent and describing the services provided. The Tax Court clearly discounts evidence based merely on testimony, memory, and logs reconstructed after the fact:
This Court has previously noted that while the regulations are somewhat ambiguous concerning the records to be maintained by taxpayers, we are not required to accept a postevent “ballpark guesstimate,” or the unverified, undocumented testimony of taxpayers. [Hoskins, T.C. Memo. 2013-36]
See also Lee, T.C. Memo. 2006-193, finding the taxpayers’ post-event time logs and trial testimony were exaggerated and “not really in the ballpark at all” when they claimed to have spent more than half of their time on rental real estate activities but were otherwise employed in unrelated full-time occupations, and D’Avanzo, 67 Fed. Cl. 39 (Fed. Cl. 2005), aff’d 215 Fed. Appx. 996 (Fed. Cir. 2007).
Submitting time logs at trial with significantly more hours than were submitted at audit has proved to be a poor strategy as well (see, for example, Lee, T.C. Memo. 2006-193, and Anyika, T.C. Memo. 2011-69). In both cases, the taxpayers apparently considered only the 750-hour requirement of the real estate professional test and then, at trial, learned of the equally important more-than-50% requirement. If taxpayers’ rental real estate activity is located far from their personal residence or a management company is involved in the rental, a contemporaneous, detailed log is even more important because, as discussed above, those situations will almost surely be subject to scrutiny in an IRS audit.
EVEN GREATER CONSEQUENCES
The taxation of rental real estate and passive losses is a battle that now holds even greater consequences with the 3.8% additional tax. This area of law was always complicated, but with good tax planning, it is one that can withstand an IRS audit.
Beginning this year, taxpayers with income or loss from passive rental real estate activities face twin perils. Besides the passive loss limitation of Sec. 469 as in previous years, high-income taxpayers may now be subject to the new 3.8% net investment income tax on such income.
Taxpayers may be able to avoid either hazard if they can establish that they materially participate as real estate professionals in their real estate activities. A qualifying real estate professional must perform more than one-half of all personal services in real property trades or businesses in which the taxpayer materially participates. These real property activities must also total more than 750 hours during the tax year.
Taxpayers must also show they materially participated in rental real estate activities by each property separately or grouped, if they elect to treat them all as a single activity. Material participation must be established under at least one of seven tests under Temp. Regs. Sec. 1.469-5T(a).
Contemporaneous logs describing activities and recording hours spent on them, while not required, are strongly encouraged as a practical means of substantiating material participation, along with other supporting substantiating documents.
Philip Garrett Panitz ( firstname.lastname@example.org ) is the senior tax partner at the law firm Panitz & Kossoff LLP in Westlake Village, Calif. Barbara Lubin ( email@example.com ) is an attorney with Panitz & Kossoff LLP.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
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