As a general rule, passive activity losses can offset only passive income and cannot be used to reduce active or portfolio income. Also, tax credits derived from passive activity can offset only taxes incurred from passive income. Any loss or credit that is disallowed becomes suspended and is treated as a deduction or credit allocable to such activity in the next taxable year.
IRC section 469 (c)(2) says any real estate rental activity automatically is treated as a passive item unless the taxpayer qualifies as a real estate professional. The Revenue Reconciliation Act of 1993 allows real estate professionals, who spend the majority of their time engaged in real estate activities, to avoid the passive loss limitations. To be eligible, a taxpayer must materially participate in the business, perform more than 750 hours of service per year in the real estate activity and be able to demonstrate that more than half of the personal services he or she performs during the year are for real property trades or businesses.
These rules apply as if each real estate rental activity is a separate business. However, IRC section 469(c)(7)(A) allows a qualifying real estate professional to elect to treat all such activities as one. Such an election not only eases the burden of meeting the material participation tests but also allows the taxpayer to currently offset the losses from one rental activity against the income of another and then offset the remaining loss against non-passive-activity income.
In Kosonen v. Commissioner, TC Memo 2000-107, an airline pilot owned seven residential rental properties. Altogether he had 877 combined hours of service in 1994 and 977 hours in 1995. He filed his 1994 and 1995 returns and reported his combined rental losses on line 42 of schedule E, where real estate professionals report the net income or loss from all rental activities in which they materially participated under the passive activity loss rules. Kosonen then reported a combined loss on line 17 of form 1040 and used the loss to offset his other income to arrive at his adjusted gross income.
In 1996, Kosonen did the same thing, except he also attached a statement indicating that he qualified as a real estate professional and elected to treat all his rental real estate activities as one activity.
The IRS agreed that Kosonen would have been considered to have materially participated in his real estate activities in 1994 and 1995 if they had been treated as one. However, since no formal election was filed prior to 1996, the service treated each property separately. Therefore, Kosonen no longer passed the material participation test, and the IRS disallowed the offset against the nonpassive income.
The Tax Court sided with the IRS, ruling that since Kosonen didn’t affirmatively elect to aggregate his real estate rental activities in order to treat them as one activity under the passive activity loss rules, his losses for the seven separate activities were suspended and thus could not be used to offset his non-passive-activity income.
Observation: CPAs should be aware that regulations section 1.469-9(g)(3) requires the taxpayer to file the aggregation election with his or her original income tax return for the year the election is made. The regulation states that once the taxpayer makes such an election, it applies for that year and for all future years during which he or she qualifies as a real estate professional.
—Michael Lynch, Esq., professor of tax accounting at
Bryant College, Smithfield, Rhode Island.