The IRS Office of Chief Counsel (OCC) in Chief Counsel Advice (CCA) 201427016 on July 3 advised on the interaction of the rental real estate grouping election under Regs. Sec. 1.469-9(g) and the real estate professional exception to the passive activity loss rules under Regs. Sec. 1.469-9(b)(6). Like all CCAs, the advice may not be cited as precedent, but it provides insight into how the IRS views this topic.
Breaking down the basics
Four relevant Code and regulations sections must be considered, and they should not be confused with one another:
- Temp. Regs. Sec. 1.469-5T material participation test (to establish that a taxpayer’s interest in a trade or business is not a passive activity);
- Regs. Sec. 1.469-9 and Sec. 469(c)(7) test for determining status as a “qualifying taxpayer” (often referred to as a “real estate professional”);
- Regs. Sec. 1.469-9(g) grouping election allowing a qualifying taxpayer to treat all rental real estate activities as a single activity; and
- Sec. 469 passive activity loss limitation rules generally.
Also note that some of these Code and regulations sections refer to rental activities, while others refer more specifically to rental real estate activities. It is also important to distinguish between the activity groupings used in applying the material participation test and the real property trades and businesses considered in determining whether a taxpayer qualifies as a real estate professional.
Real estate professional and material participation tests
A key element of confusion, as highlighted by this CCA, is the separate application of the real estate professional test in Sec. 469(c)(7)(B) and Regs. Sec. 1.469-9(c) and the material participation test for activities of Temp. Regs. Sec. 1.469-5T. The tests are similar in their use of qualifying hours of service and in their application, but they have distinct purposes. Either the material participation test will apply, or both tests will apply—first the real estate professional test and then the material participation test.
A third layer of complexity, the Regs. Sec. 1.469-9(g) grouping election, is discussed below. As the OCC explained in the CCA, the election is available only to a qualifying real estate professional. Therefore, the OCC advised that the fact that the taxpayer had not made a Regs. Sec. 1.469-9(g) grouping election did not have an effect on whether the taxpayer qualified as a real estate professional under Sec. 469(c)(7) and Regs. Secs. 1.469-9(b) and (c).
Consequences and mechanics of the interacting code sections
If the taxpayer is not active in any qualifying real property trades or businesses, the taxpayer cannot be a real estate professional. The Temp. Regs. Sec. 1.469-5T material participation tests are applied only to the taxpayer’s nonrental activities to determine if they are passive activities, and all rental activities are treated as passive activities, regardless of the taxpayer’s level of participation.
To determine whether the rental activities of a taxpayer who is active in one or more qualifying real property trades or businesses (as defined in Sec. 469(c)(7)(C)) are passive, first the real estate professional test is applied to the taxpayer, and then the material participation test of Temp. Regs. Sec. 1.469-5T is applied to the rental activities. Real property trades or businesses include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Simply qualifying as a real estate professional does not preclude a taxpayer’s rental activity from being treated as a passive activity. As the CCA points out, it merely provides the opportunity to apply the material participation tests to the qualifying taxpayer’s rental real estate activities to determine if they are passive.
Qualifying as a real estate professional
To qualify as a real estate professional, Sec. 469(c)(7)(B) requires that more than one-half of the personal services performed by the taxpayer in trades or businesses during the tax year be performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer must perform more than 750 hours of personal services during the tax year in real property trades or businesses in which he or she materially participates. A taxpayer may use any reasonable method of applying the facts and circumstances in determining the real property trades or businesses in which he or she provides personal services. Under a consistency requirement, once a taxpayer determines the real property trades or businesses in which personal services are provided, the taxpayer may not redetermine those real property trades or businesses in subsequent tax years, barring a material change in facts and circumstances that makes the grouping clearly inappropriate, or if it is determined that the original grouping was clearly inappropriate (Regs. Sec. 1.469-9(d)).
If the taxpayer meets these requirements, the next hurdle is to apply the material participation tests to the rental real estate activities. This is where the grouping election of Regs. Sec. 1.469-9(g) can come into play.
Material participation test and the grouping election
Under Sec. 469(c)(7)(A), each interest of the taxpayer in rental real estate is treated as a separate activity for purposes of determining whether the taxpayer materially participates in the rental real estate activity, unless the taxpayer, in a year in which the taxpayer qualifies as a real estate professional, elects under Regs. Sec. 1.469-9(g) (the grouping election) to treat all interests in rental real estate as a single rental real estate activity for the material participation tests of Temp. Regs. Sec. 1.469-5T. The grouping election applies to the current tax year and all future tax years, even if there are intervening tax years in which the taxpayer is not a real estate professional.
The failure to make the election in one year does not preclude the taxpayer from making the election in a subsequent year. In years in which the taxpayer is not a real estate professional, the election will have no effect, and the taxpayer must group the activities according to the general grouping rules in Regs. Sec. 1.469-4. Once the taxpayer makes the election, it may be revoked only in the event of a material change in circumstances.
A failure to make the election could lead to an unfavorable result where the taxpayer qualifies as a real estate professional but does not pass the material participation tests for each activity. A missed grouping election for rental real estate activities can be costly. However, making the election will not always yield favorable results for a taxpayer, and there are limitations on the revocation of the election. Therefore, each taxpayer’s circumstances should be considered carefully before the election is made.
Editor’s note: A version of this article appeared as “ Tax Clinic: IRS Provides Guidance on Interplay of Rental Real Estate Grouping Election and Real Estate Professional Exception ,” The Tax Adviser, Nov. 2014, page 788.
By Adam Miles, CPA (firstname.lastname@example.org), SingerLewak LLP, Irvine, Calif.
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