Passive loss limitations on rental real estate

As the popularity of short-term rentals through services such as Airbnb and Vrbo continues, CPAs more often face questions from their tax clients of how rental income and expenses are treated for tax purposes. Those with losses from the activity may expect it will offset other taxable income. Thus, it is critical for tax practitioners to educate these clients regarding the Sec. 469 passive activity loss limitation rules and their exceptions. CPAs can then proactively advise them how to maximize tax benefits where opportunities exist and minimize surprises come tax time.

SEC. 469 AND PASSIVE ACTIVITIES

Sec. 469 defines a passive activity as any activity that involves a trade or business in which an individual taxpayer does not materially participate. For this purpose, a trade or business includes an activity for the production of income for which expenses are deductible under Sec. 212 (Sec. 469(c)(6)). Whether an individual materially participates in an activity is generally determined under the seven tests for material participation set out in Temp. Regs. Sec. 1.469-5T(a), which are discussed below.

Losses generated by passive activities (passive activity losses, or PALs) are allowed only to the extent of income generated by passive activities (passive income). Any PALs that cannot be used due to this limitation (suspended passive losses) are carried forward to subsequent years until they can be deducted against passive income (Sec. 469(b)). In the year an entire activity is disposed of in a “fully taxable” transaction, any remaining suspended passive losses are no longer treated as PALs and are deductible (Sec. 469(g)).

Rental real estate activities are per se passive

In an exception to the material-participation standard, Sec. 469(c)(2) states that the term “passive activity” includes any rental activity, regardless of whether the taxpayer materially participates. Thus, rental real estate activities are commonly referred to as per se passive activities.

So, what does Sec. 469 and its application to rental real estate activities mean for an average landlord? Let’s look at a simple example, assuming this individual’s only other taxable income is wages of $200,000 with income and expenses from a single real estate rental property in 2023 as shown in the table “Income and Expenses From Rental Activity,” below.

Income and expenses from rental activity For tax purposes, the net rental loss for the year will be limited to $0, with $10,500 of PALs carried over to 2024. The individual’s taxable income for the year is $200,000, with $10,500 of suspended PALs. If the individual had $5,000 of net passive income from another source, the loss from the rental property would be available to offset that income, such that net passive income would be $0, with $5,500 of suspended PALs carried over to 2024.

Active participation

A limited exception from the PAL rules exists for individuals with a rental real estate activity who participate in the activity but whose participation does not rise to the level of material participation. For individuals who “actively participate” in the rental activity and whose adjusted gross income (AGI) is less than $150,000 ($75,000 for married taxpayers filing separately), up to $25,000 of net passive losses from rental real estate are allowed to offset other taxable income each year (Sec. 469(i)). AGI for this purpose does not include any allowable passive activity or real property business losses.

Active participation does not require as much involvement in the activity as material participation. Active participation can consist of making management decisions, but it excludes any activity in which the taxpayer owns less than 10% (by value) of all interests in the activity or an interest as a limited partner in a limited partnership (Sec. 469(i)(6)). If the taxpayer is married, however, the spouse’s participation also counts.

The $25,000 starts to phase out at an AGI of $100,000 ($50,000 for married filing separately) and is reduced by 50% of the amount by which the AGI exceeds this threshold. In the example above, if the individual’s AGI were $130,000, the maximum $25,000 allowance would be reduced by: ($130,000 – $100,000) × 50% = $15,000, allowing them to deduct up to $10,000 ($25,000 – $15,000) of total net rental losses. The remaining $500 of PAL would be carried over.

Short-term rentals

Under Temp. Regs. Sec. 1.469-1T(e)(3)(ii), short-term rentals, i.e., in which the average rental period is either (1) seven days or less or (2) 30 days or less (with significant personal services provided by or on behalf of the taxpayer) are not classified as rental activities. Thus, short-term rentals (as Airbnb rentals often are) are not considered per se passive, the $25,000 rental real estate allowance for active participation does not apply, and hours spent in short-term rentals do not count toward meeting the real estate professional tests discussed below. The determination of whether a short-term rental activity is passive or nonpassive depends on whether the individual materially participated in the activity, as discussed below.

Self-rental rule

Under the self-rental rules (Temp. Regs. Sec. 1.469-2T(f)(6)), if an individual rents property to an activity in which the individual materially participates (which is not property rented incidental to a development activity under Temp. Regs. Sec. 1.469-2T(f)(5)) and generates net rental income for the year, such net income (including any gains from the sale or disposition of the property) is recharacterized as nonpassive income for that year. This is to prevent taxpayers from inflating rent to free up passive losses from other activities. If the property generates a net loss for the year, the losses continue to be passive.

REAL ESTATE PROFESSIONAL

As noted above, rental activities are generally per se passive activities, regardless of an individual’s level of participation in the activities. However, if an individual qualifies as a real estate professional, the individual’s rental real estate activities are not per se passive and will not be passive activities if the individual materially participates in the activities.

To qualify as a real estate professional, an individual must satisfy two time-related requirements during the applicable tax year:

1. More than 50% of all personal services performed in trades or businesses by the individual during the year were performed in real property trades or businesses in which the individual materially participated; and
2. The individual must have worked more than 750 hours in real property trades or businesses in which the individual materially participated (Sec. 469(c)(7)(B)).

Real property trades or businesses are defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business” (Sec. 469(c)(7)(C)).

If an individual has a full-time job outside the real property business, it will be very difficult, if not impossible, to meet these tests. Also, services performed as an employee do not count unless the employee is at least a 5% owner. In addition, unlike with the $25,000 rental real estate allowance for active participation discussed above, a spouse’s personal services are not attributed to a taxpayer for purposes of meeting these time requirements.

The determination of whether an individual qualifies as a real estate professional is made annually, meaning an individual could qualify one year but not the next. If an individual qualifies, contemporaneous documentation to support how one spent one’s time in a manner that meets these requirements is critical in the event of an IRS audit.

CPAs should impress upon clients that the IRS and courts will scrutinize their time records for completeness, accuracy, and plausibility; a “ballpark guesstimate” will not suffice (see Bailey, T.C. Memo. 2001-296). Time logs must reflect hours in which taxpayers actually performed services in their real property trades or businesses. Time spent “on call” for work at rental properties in a rental real estate activity, for example, does not count (see Moss, 135 T.C. 365 (2010)).

As noted above, an individual who qualifies as a real estate professional does not automatically get to treat all rental real estate activities for the year as nonpassive. The individual must still materially participate in each rental real estate activity for it to be nonpassive. Under Sec. 469(c)(7), however, an individual can elect to aggregate all rental real estate activities and consider all such activities as one activity for purposes of determining material participation. The election is advantageous when an individual is involved in multiple rental activities and the taxpayer would have difficulty meeting any of the material-participation tests (discussed below) for each activity separately. Taxpayers should give careful consideration before making the election, however, as it is irrevocable.

Also, note that not all states conform to the real estate professional exception. For example, California does not conform, meaning that rental real estate activities of a real estate professional are still treated as per se passive for California personal income or franchise tax purposes.

MATERIAL PARTICIPATION

Temp. Regs. Sec. 1.469-5T(a) provides seven tests by which an individual can prove material participation in a trade or business. If any one of these seven tests is met (and assuming the per se passive designation for rental activities is overcome by meeting the real estate professional exception), an individual is considered to have materially participated in a rental real estate activity, and that activity is treated as nonpassive for that tax year (and not subject to the passive loss limitations):

1. The individual participates in the activity for more than 500 hours during the tax year.

The Sec. 469(c)(7) election to treat all rental real estate activities as a single activity is particularly helpful in meeting this test. For example, a real estate professional has five separate rental activities and spent 110 hours in each. Looking at each activity separately, the real estate professional fails this test. However, by making the election to aggregate, the real estate professional has spent 550 hours in the combined rental real estate activity and thus meets the test.

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 those who are not owners) for that year.

An individual who does all or almost all of the work in a rental activity would meet this test, but if an outside management company is hired, the 500-hour test is likely the only test the individual will satisfy. Even if occasional third-party help (such as cleaners, landscapers, repairers, or plumbers) is used, it may be difficult to meet this test.

3. The individual participates in the activity for more than 100 hours during the tax year, and their participation in the activity for the year is not less than the participation in the activity of any other individual (including those who are not owners) for that year.

This is a slight variation of test No. 2, allowing for more outside help but first requiring at least 100 hours of the individual’s own involvement. For example, if an individual spent 120 hours on the activity during the year, they could hire a maintenance worker and a cleaner to work up to 119 hours each and still meet this test.

4. The activity is a significant-participation activity for the tax year, and the individual’s aggregate participation in all significant-participation activities during the year exceeds 500 hours.

A significant-participation activity is a trade or business activity in which the individual spent more than 100 hours but fewer than 500 hours during the year. Note that for this test, a trade or business does not include rentals. This test is therefore not available to a real estate professional.

5. The individual materially participated in the activity (by meeting any of the other six tests) for any five tax years (whether or not consecutive) out of the 10 tax years immediately preceding the tax year.

6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.

This is a variation of test No. 5, with a slightly less stringent criterion for personal service activities. An activity is a personal service activity if it involves the performance of 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. Rental real estate is not a personal service activity, so this test is also not available to a real estate professional.

7. Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

This test does not apply unless the individual participated in the activity for more than 100 hours during the year. Time managing the activity does not count in determining whether the individual materially participated under this test if any person received compensation to manage the activity or if any person spent more hours than the taxpayer managing the activity.

WHAT COUNTS AS PARTICIPATION IN THE ACTIVITY?

In general, any work done by individuals in connection with a rental real estate activity in which they own an interest is treated as participation in the activity for purposes of the material-participation tests. Under Sec. 469(h)(5), an individual’s participation includes the spouse’s participation in an activity. Some exceptions apply to the general rule, including:

Work not usually performed by owners

Work is not treated as participation in the activity if (1) it is both not the type of work customarily done by an owner of a rental real estate activity, and (2) one of the principal purposes the individual is doing the work is to avoid the disallowance of losses or credits due to the passive activity rules.

Investor work

Unless an individual is involved in day-to-day management or operations of the activity, work in the capacity as an investor in the activity is not participation in the activity. According to Temp. Regs. Sec. 1.469-5T(f)(2)(ii)(B), work as an investor includes 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 one’s own use, and monitoring the finances or operations of the activity in a nonmanagerial capacity.

FULLY TAXABLE DISPOSITIONS

If a taxpayer does not have passive income from rental real estate or other sources to allow the use of passive losses generated by rental real estate activity, losses from that activity will continue to be carried over each year until the entire activity is sold in a fully taxable disposition.

The requirement that a disposition be “fully taxable” means that certain tax-free or tax-deferred transactions will not result in the release of passive loss carryovers upon a transfer of such property. This includes, but is not limited to, gifts, contributions to or distributions from a partnership, transfers due to death, and Sec. 1031 like-kind exchanges. Tax practitioners should keep this in mind so that passive losses are not erroneously accelerated when such a transaction occurs. This can happen when relying on tax preparation software, which often provides a box to indicate a 100% disposition and will release any PALs attributed to the activity.

Because the entire activity must be disposed of for the suspended losses from the transaction to be deductible, if a real estate professional has made the irrevocable election to group multiple rental real estate activities together as a single activity, any suspended passive losses from such activities generally will not be freed up until all such activities have been disposed of in a fully taxable transaction. Because the election is to treat all the activities as a single activity, the disposition of one of the grouped activities is considered a partial disposition of the grouped activity, not a disposition of the entire activity.

However, if substantially all of the activities that are grouped as a single activity are disposed of in a partial disposition and certain requirements are met, the suspended passive losses associated with the disposed-of activities will be allowed.

EQUIPPED TO ADVISE CLIENTS

This article is intended to be a road map and overview of the more common tax issues as they relate to rental real estate activities, so that tax practitioners can properly advise their clients and properly report such activities. The PAL rules under Sec. 469 are complex and nuanced, and the per se passive rule that applies to rental real estate adds another layer of complexity.

It is particularly critical for clients who qualify as real estate professionals to have tax advisers who know to consider the aggregation election, advise them of the importance of concurrent documentation, and understand the material-participation rules. Also, when dealing with clients who rent out their properties on a short-term basis, it is helpful to keep in mind that short-term rentals are not considered rental activities that are per se passive under the PAL rules. Having this high-level understanding of the Sec. 469 rules will better equip tax practitioners to navigate them with their clients.

About the author

Celia Lau, CPA, is a partner with Navolio & Tallman LLP in Walnut Creek, Calif. To comment on this article or to suggest an idea for another article, contact joaed@aicpa.org.

AICPA RESOURCES

Articles

“Tax Rules for Real Estate Professionals,” May 21, 2020

“Interplay of the Rental Real Estate Grouping Election and Real Estate Professional Exception,” JofA, Dec. 2014

“Electing to Aggregate Rental Activities: Better Late Than Never,” JofA, Aug. 2014

“Short-Term Rentals Preclude Use of Losses,” JofA, Nov. 2011

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