Real Tax Savings in Real Estate

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 other sources.

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
By 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 activities.

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 criteria:

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
A “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 year.

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 disposed of.

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 participation.

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 position.

BURDEN OF PROOF
Taxpayers also 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).

Taxpayers 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
If 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.

This loss 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 participation.”

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.

The 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 business

Extent of common control and ownership

Geographic location

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.

The 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).

Consequently, 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.

AICPA RESOURCES JofA article “Tax Matters: Aggregating Your Rental Activity? Be Sure to Tell the IRS,” July 00, page 71 CPE AICPA’s Individual Income Tax Returns Workshop by Sid Kess , a CPE self-study course (#735222) AICPA’s Individual Tax Review Series: Nuts and Bolts , a CPE self-study course (#733650) AICPA’s Individual Tax Review Series: Beyond the Basics , a CPE self-study course (#733630) For more information or to place an order, go to www.cpa2biz.com or call the Institute at 888-777-7077.