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:
- The taxpayer participates in the activity more than 500 hours during the year;
- The taxpayer’s participation in the activity constitutes substantially all of the participation by all of the individuals (including non-owners), for the year;
- 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;
- 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;
- 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);
- 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
- 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.
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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.