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The Real Estate Professional, Part II

In Part I, we discussed the special rules regarding real estate investment losses for real estate professionals. We noted that unlimited deductions for real estate losses may be taken only if specific requirements are met. The first requirement is that the taxpayer is engaged as a real estate professional (meaning, the taxpayer is engaged in one of the trades or businesses set forth under IRC Sec. 469(c)(7)(C)), it will then apply a series of tests to determine whether they are dedicating sufficient time and are "materially participating" in that trade or business.

The 50% and 750 Hours rules

The taxpayer will need to demonstrate that more than half of their personal services in all of their business ventures for the taxable year were performed in the area of real property businesses and rentals (the rationale is that if you argue that you are making your living in real estate, you should be able to show that at least half of your time is spent in that area). The taxpayer must also show that the time they spend materially participating in real property businesses and rentals exceeds 750 hours during the year.

Needless to say, taxpayers with very time-intensive careers have difficulty meeting these criteria. Courts are skeptical when full-time teachers, lawyers and doctors, for example, claim that they have the time to hold a full-time job (52 weeks x 40 hours/ week = 2,080 hours per year) and spend even more time than that on their rental business. For example, in the recent Escalante v. Commissioner case, a teacher’s failure to account for time spent preparing for class, attending faculty and parent-teacher meetings, and attending other school functions did not go unnoticed by the Court. 

We highly recommend keeping detailed time records to demonstrate the time spent on real estate and other activities – the Tax Court will likely reject what it considers a “ballpark guestimate.” In Merino v. Commissioner, for instance, the Court rejected the taxpayer’s summary which he acknowledged was prepared "using his estimates and his memory as to how much time he spent on certain tasks with respect to the real estate rental activity."

The Material Participation Test

If a taxpayer meets the requirements of both the 50% and 750 hours rules, then the “material participation” test will be applied to determine if each of the taxpayer’s activities is active or passive. Treas. Reg. Section 1.469-5T sets forth seven different ways to establish that a taxpayer materially participates in any specific real estate activity:

  1. The taxpayer participates in the activity more than 500 hours during the year;
  2. The taxpayer’s participation in the activity constitutes substantially all of the participation by all of the individuals (including non-owners), for the year;
  3. The taxpayer’s participation is more than 100 hours during the year, and no one else (including non-owners) puts more hours into the activity than the taxpayer;
  4. The activity is a trade or business activity in which the taxpayer significantly participates, and the taxpayer’s aggregate participation in all such activities during the year exceeds 500 hours;
  5. The activity is a personal service activity in which the taxpayer materially participated for any three tax years preceding the current tax year, or for any five of the preceding ten taxable years (they need not be consecutive);
  6. The activity is a personal service activity and the taxpayer materially participated in the activity for any three taxable years preceding the taxable year (they need not be consecutive); OR
  7. The taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis during the year.

Under IRC § 469(c)(7)(A)(ii) a taxpayer may make a one-time election to group all their rental activities as a single activity for the purpose of the material participation test. 

A full service tax firm in San Francisco

Note that the different material participation tests apply to different real estate activities, and there are special rules for closely held corporations. If you wish to maximize your tax deductions, first consult the tax team at Moskowitz, LLP

The Real Estate Professional, Part I

For the past 8 years, the IRS has been cracking down on investors who attempt to use their passive real estate investment losses to offset other income.

IRC §467 limits an investor’s ability to use passive losses to offset their ordinary or earned income. As a general rule, passive losses may be used only to offset passive income, and rental activities are generally considered passive under this code section. Taxpayers who “actively participate” in their rentals (e.g., select or approve tenants, negotiate leases, manage property repairs and capital improvements) are entitled to a maximum $25,000 offset under IRC §467(i). Note that per IRC §467(i)(3), the $25,000 loss will be reduced by 50% if the taxpayer's adjusted gross income exceeds $100,000.

Special passive loss rules for real estate professionals

IRC §467(c)(7) provides special rules regarding real estate investment losses for real estate professionals. For taxpayers who qualify, all losses connected with their real estate investments may be applied without limitation. It is no wonder that so many taxpayers with real estate interests try to fit themselves into this classification!

What is a Real Estate Professional?

IRC Sec. 469(c)(7)(C) defines a real estate professional as someone who spends the majority of their time in one or more of the following real estate trades or businesses:

 

  • Real property development or redevelopment
  • Construction or reconstruction
  • Acquisitions
  • Rental or leasing
  • Operation or management
  • Brokerage trade or business

 

Being in the business isn’t enough. Under IRC Sec. 469(c)(7)(B), to receive an unlimited real estate investment deduction, a taxpayer must also demonstrate that more than 50% of their activities, and more than 750 hours of their time, during the taxable year at issue was spent “materially participating” in a real property trade or business.

"Material participation" - a higher standard

The “material participation” standard that allows all real estate investment losses to be deducted is a much stricter standard than the “active participation” requirement for a $25,000 offset under IRC §467(i). In Part II, we will review the time tests, the requirements of “material participation” and provide some tips on how to increase the likelihood of your deductions surviving an audit.

Skilled and aggressive tax audit representation

In the area of real estate loss deductions, IRS auditors tend to cast an exceptionally wide net. If you are a real estate investor whose deductions have been disallowed and/or you are being audited, you need a highly skilled and aggressive tax attorney on your side. The tax lawyers at Moskowitz, LLP have vast experience representing thousands of clients before the IRS and state taxing agencies. We welcome your call.

 

Also see: Part II