While the passive loss
limitation rules generally prevent the
current deduction of rental real estate net
losses, many taxpayers with real
estate rental income may meet the standard for
a real estate professional conducting a real
property trade or business. Such status
requires the taxpayer to “materially
participate” in the trade or business by
meeting tests of IRC § 469 and Temp. Reg. §
Taxpayers may elect to
group all their interests in rental
real estate activities into a single activity,
which can help them meet the above tests if
they lack sufficient hours to qualify for any
single activity. The election could, on the
other hand, prevent taxpayers from claiming a
loss on disposal of less than all their
properties so combined.
A taxpayer who exhibits
“active participation,” a lower
standard than material participation, may
still be eligible for a $25,000 special loss
Certain rental real
estate activities may be grouped
with related operating activities
that constitute an “appropriate economic unit”
based on interdependencies between the
activities and other factors identified in
Treas. Reg. § 1.469-4.
Elizabeth Murphy, CPA, and
Keith Gunter, CPA, are a
tax partner and tax manager, respectively, at
Dixon Hughes PLLC, based in the Southeast.
Their e-mail addresses, respectively, are email@example.com
More and more frequently, CPAs’ clients are
becoming involved with the national real estate
market. Perceived opportunities to buy and sell
foreclosure properties, along with time and energy
spent repairing property damaged by recent natural
disasters, mean many clients are spending much of
their time and effort with rental real estate. But how
they go about it can make a big difference in whether
transactions are considered investment activity,
subject to loss limitations, or the result of a trade
or business, in which losses can offset income from
This article outlines how
clients can realize tax advantages from being a
material participant in a real estate trade or
business rather than a passive investor in real
estate. Careful documentation is all the more
necessary as the IRS steps up compliance efforts. In
many cases, people who consider themselves real estate
professionals bear the burden of proving they are
properly classified under the rules.
PASSIVE LOSS LIMITATIONS
statute, rental real estate activities are “passive”
and thus subject to the passive loss limitation rules
of IRC § 469(c)(2). Generally, under those rules, all
aggregate losses from passive activities are limited
to the amount of aggregate income from passive
Taxpayers who conduct a “real
property trade or business,” however, may qualify to
treat otherwise passive rental real estate activities
as nonpassive. Thus they may be able to offset wages,
investment earnings and other sources of taxable
income with net rental real estate losses. Such a
taxpayer is referred to as a “materially participating
real estate professional” and must meet the following
For any tax year, performs more than 50%
of his personal services in real property trades or
businesses in which he materially participates, AND
Performs more than 750 hours of service
during the tax year in real property trades or
businesses in which he materially participates. See
IRC § 469(c)(7).
TYPES OF TRADE OR BUSINESS
“real property trade or business” may be one of the
following: development or redevelopment; construction
or reconstruction; acquisition; conversion; rental;
operation; management; leasing; or brokerage. Again,
the taxpayer simply has to perform more than 750 hours
of service and spend more than 50% of his or her
personal service hours in a combination of
the above activities to meet the threshold.
Another set of tests for material participation in
nonpassive activities generally is found in Temp. Reg.
§ 1.469-5T(a). Taxpayers must meet ONE of these basic
standards, as applied to both of the criteria above.
However, if the taxpayer has met the 750-hour
requirement above, he or she will also meet one of
these tests, that he or she participates in the
activity more than 500 hours during the year. The
other tests of Temp. Reg. § 1.469-5T(a) are:
The taxpayer’s participation in the
activity for the current year constitutes
substantially all of the participation of all
individuals (including individuals who are not owners
of interests in the activity). A one-person operation
is generally regarded as meeting this requirement.
The taxpayer participates for more than
100 hours during the year, and the taxpayer’s
participation is not less than any other individual’s
participation during the year.
The activity is a significant
participation activity, and the taxpayer’s total
participation in all significant participation
activities exceeds 500 hours. A significant
participation activity is one where (a) the taxpayer
cannot be treated as materially participating under
any of the other six tests, and
(b) the taxpayer participates for more than 100
hours but fewer than 500 hours.
The taxpayer materially participated in
the activity for any five of the 10 immediately
preceding tax years.
The activity is a personal service
activity, and the taxpayer materially participated in
the activity for any three years preceding the current
Facts and circumstances indicate there
was material participation on a regular, continuous
and substantial basis.
ELECTION A POTENTIAL LIFESAVER
For purposes of meeting the “real estate
professional” requirements, each rental real estate
activity is tested separately, unless the taxpayer
makes an election under IRC § 469(c)(7)(A) to group
all interests in rental real estate activities into a
single activity. The election is made by filing an
attachment to the taxpayer’s original income tax
return for the year for which the election is
effective. Once made, the election is effective for
all subsequent years; it can be revoked, however, by
attaching a statement to the taxpayer’s return,
explaining the nature of the taxpayer’s material
change in facts and circumstances warranting the
revocation. This simple election can be a lifesaver
for real estate professionals who may meet the hours
standards in total but spend insufficient hours on any
one real estate activity.
This election can be
disadvantageous, however, to a taxpayer who owns
several properties that generate losses if the
taxpayer expects to dispose of one of these properties
at a loss. When the election has been made, losses
from fully taxable dispositions can only be taken if
“substantially all” of the taxpayer’s interest in the
activity is disposed of. If the election is in place,
the disposition of one property generally will not be
viewed as disposing of “substantially all” of the
taxpayer’s activity, and the loss will therefore be
disallowed until all of the properties have been
Taxpayers can substantiate
participation in an activity using any reasonable
method. See Treas. Reg. § 1.469-5T(f)(4).
Contemporaneous daily reports or logs are not
required, but rather appointment books, calendars and
narrative summaries that document the approximate
number of hours spent and a description of qualifying
services will suffice. The IRS may scrutinize such
records closely, however, so your clients should make
sure their records are credible and sufficiently clear
and specific to support their claim of material
Another reasonable approach may
be to consider the regulations under IRC § 274 that
describe how to substantiate the business purpose of
travel and entertainment expenses. By analogy, a
taxpayer who keeps a daily log of qualifying real
property trade or business activities describing the
purpose of appointments, trips, expenses and the
amount of time spent on those activities will surely
have a much easier time supporting his or her
BURDEN OF PROOF
have the burden of proving that they are involved in a
real estate trade or business. Relevant court cases
include Duffy v. U.S. (81-1 USTC), Peck
v. Commissioner (44 TCM 1030), Gorod v.
Commissioner (42 TCM 1569), and Slack v.
Commissioner (35 B.T.A. 271).
must ensure their overall recordkeeping for real
estate activities supports their position as a
materially participating real estate professional.
Sound recordkeeping might include:
Segregating inventory property from
investment property in the taxpayer’s books and
records, preferably into separate legal entities.
Documenting the original intent for
holding a property, for example, in partnership
operating agreements or letters to a file.
Properly tracking and reporting expenses
related to property held for inventory, such as when
your client acquires a house with the intention of
“flipping” it, as ordinary business expenses.
SPECIAL LOSS ALLOWANCE
taxpayers do not have sufficient involvement in rental
real estate to meet the material participation and
real estate professional tests described above, they
may still benefit from another exception to the
general rule limiting passive activity losses. IRC §
469(i) provides for a $25,000 special loss allowance
for net rental real estate losses.
allowance applies where:
A taxpayer (or spouse) actively
participates in the rental activity. “Active
participation” requires a minimum 10% ownership
interest in the rental property and substantial
involvement in its management. Note that “active
participation” is a lower standard than “material
The ownership interest is not held via a
limited partnership interest.
The $25,000 loss allowance is figured by
netting all of the rental real estate activities in
which the taxpayer actively participates.
special loss allowance begins to phase out when
modified adjusted gross income (AGI)
exceeds $100,000 and is reduced to zero when modified
AGI reaches $150,000. The modifications to AGI
include, but are not limited to, adding back any net
passive loss and any rental losses allowed due to
material participation as a real estate professional.
Notably excluded from the computation of
modified AGI are contributions to health savings
accounts and tax-exempt investment earnings. For
taxpayers who meet the other requirements, the tax
practitioner may have a tax planning opportunity to
help the taxpayer meet the modified AGI limits.
ELECTION TO GROUP RELATED ACTIVITIES
An election not to be overlooked in navigating
the rental real estate loss limitations is the
opportunity to group certain rental real estate
activities with related operating activities, thereby
offsetting the operating income with the rental real
estate losses. (Note that rental real estate
activities cannot be grouped with personal property
rental activities.) Under Treas. Reg. § 1.469-4, a
rental real estate activity may be grouped with an
operating activity if it constitutes an “appropriate
economic unit” AND meets the following criteria:
The rental activity is insubstantial in
relation to the business activity (or vice versa), OR
Each owner of the trade or business
activity has the same proportionate ownership interest
in the rental activity.
Treas. Reg. §
1.469-4(c)(2) identifies the following factors when
considering whether activities constitute an
“appropriate economic unit”:
Similarities and differences in types of
Extent of common control and ownership
Interdependencies between the activities
An example of the benefits of the “appropriate
economic unit” rule may be found in Glick v. U.S.
, 86 AFTR2d 2000-5083 (96 F.Supp.2d 850). In this
case, the Glicks (husband and wife) owned general
partner and/or debt interests in 116 limited
partnerships; each partnership owned a specific
low-income housing apartment project. The Gene B.
Glick Co. Inc. (GBG), an S corporation owned 93.57% by
the Glicks, managed the apartment projects for a fee.
GBG existed solely to provide management services to
the apartment limited partnerships and provided all of
the required services, either directly or by hiring
third-party vendors to supply them.
district court for southern Indiana found that GBG and
the partnerships “worked as an interrelated and
integrated single business unit, rather than as two
distinct entities who happened to provide services to
each other. … This close operating relationship of GBG
and the partnerships indicates that they were two
parts of a single economic enterprise.” The court
analyzed the quantitative facts in the relationship
between GBG and the partnerships, finding that “GBG
clearly had no role beyond providing services to the
partnerships. It was subservient to and totally
dependent upon the partnerships for its revenue as
well as its existence.” From this conclusion, the
court ruled in favor of the taxpayer and allowed the
passive losses generated from the Glicks’ limited
partnership interests to offset the fee income
generated by their S corporation.
AUDITS MORE COMMON
The IRS has
acknowledged that increasing its number of audits of
returns with real estate rental income is part of its
strategy to help close the tax gap (see “Real-Estate
Professionals Say IRS Snares Them by Mistake,” The
Wall Street Journal , Feb. 28, 2007).
Practitioners may find their clients with such income
will be closely scrutinized and required to prove
their material participation with clear records (see
Tax Matters: Passive or Nonpassive Activity—IRS Wins
Either Way,” page 74).
your client letters might include mention of the
passive rental activity rules. Client interview
questions regarding the taxpayer’s involvement in
rental real estate should be a part of your tax
planning and compliance. Clients who are just getting
started in real estate or contemplating doing so will
no doubt appreciate a tip in time to plan their
recordkeeping, and for those who are already pros, a
reminder never hurts.
Matters: Aggregating Your Rental Activity?
Be Sure to Tell the IRS,” July 00, page
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