Rental Losses, In General
As a general rule, all rental activities are considered "passive" - a category of business activities defined by the IRS - under Section 469, regardless of the extent to which the taxpayer participates in the rental. As a result, losses from a rental activity are generally only permitted to reduce income from passive activities (although, there is a limited $25,000 loss deduction available to certain taxpayers who "actively participate" in their rentals).
There is a large exception to this default treatment of rental activities as passive, however, for so-called "real estate professionals." If a taxpayer qualifies as a real estate professional and can also establish that he materially participates in the rental activities, the rentals become non-passive, and any losses can be used without limitation to offset income from any category: Earned, Portfolio, OR Passive.
Real Estate Professional Rules, In General
In a Code built on confusion, there are few areas as routinely misinterpreted and misapplied as the real estate professional rules of Section 469(c)(7). No one is above making a mess of this section of the statute; they have been mishandled by taxpayers, tax advisors, IRS agents, and even Tax Court judges for many years.
Finally, however, the IRS has laid out some tangible guidelines we can use to determine if you qualify as a Real Estate Professional:
To ensure that the benefit of the exception is preserved for those who truly deserve it, Section 469(c)(7) requires that two quantitative tests be satisfied in order for a taxpayer to qualify as a real estate professional. Here are the tests, with my plain English definition in the parenthetical:
1. More than one-half of the personal services you perform in all trades or businesses for the tax year must be performed in real property trades or businesses in which you materially participate (you must spend more hours on real estate activities than non-real estate activities, to prove that you earn your living in the real estate world), and
2. You must perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate. (This minimum-hour requirement prevents a retiree who spends 400 hours a year managing a rental property from qualifying).
Real Property Trades or Businesses
Very important to this discussion is the fact that the term "real property trades or businesses" encompasses far more than simply the rental of property; in fact, the statute lists nearly a dozen activities that constitute a real property trade or business, including development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
Thus, you do not have to be a landlord to be a real estate professional, a fact that plays a huge role in the ongoing struggle many experts have in deconstructing Section 469, and one I will address again shortly when we tie this all together.
You may have noticed that both quantitative tests hinge on your "material participation" in the real property trade or business. For this standard, we turn our attention to Reg. Section 1.469-5T, which provides seven ways in which you can establish that you materially participate in a trade or business:
1. You participate in the activity for more than 500 hours during the year,
2. Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
3. Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than the taxpayer,
4. The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours. [A significant participation activity is generally a trade or business activity (other than a rental activity) that you participate in for more than 100 hours during the year but do not materially participate in (under any of the material participation tests other than this test),]
5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,
6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
7. A generic facts and circumstances test.
LET'S PUT IT ALL TOGETHER- KNOCK OUT THESE FOUR TESTS AND YOU'RE CONSIDERED A REAL ESTATE PROFESSIONAL
1. Participate in a real property trade or business as defined by the statute.
2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T.
3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job.
4. The time spent participating in real property trades or businesses—but only those real property trades or business in which you materially participate—must exceed 750 hours.
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