Updated August 12, 2022
One of the biggest attractions of investing in real estate is the ability to offset your ordinary income with your rental real estate losses, right? Wrong!
As many of our readers probably know, not all income types are created equal. Generally speaking, one cannot offset his or her salary with losses generated from rental real estate. Although there are exceptions to this rule, in tax speak, we say that “active income” cannot be offset with “passive losses.” And rental real estate activities are considered passive.
However, not all taxpayers are created equal. Paraphrasing a famous quote from George Orwell, some taxpayers are more equal than others. The disallowance of offsetting active income with rental real estate passive losses does not apply to real estate professionals. So, what does one need to do to qualify for this tax benefit?
Real estate professional tax rules are quite complex. In this article we will only scratch the surface and aim to raise awareness of real estate professional requirements.
A qualified real estate professional is a taxpayer who owns at least one interest in rental real estate that:
The IRS defines “material participation” as regular, continuous and substantial involvement in business operations. The material participation requirement is satisfied if you meet any one of seven tests. In the case of a joint return, the couple meets the requirements if either spouse separately satisfies them. Additionally, a 2015 Tax Court ruling held that a married taxpayer filing separately must separately satisfy the requirements of IRC Section 469(c)(7)(B) to avoid per se passive activity loss treatment.
The real property trades or businesses in which a taxpayer must materially participate to qualify as a real estate professional don’t necessarily involve rental real estate. In addition to the renting and leasing of realty, real property trades or businesses include enterprises such as construction, development, buying, operating and managing realty, as well as realty brokerage businesses.
For example, a real estate broker or a home construction business owner who materially participates in the brokerage or construction business, and who satisfies the more-than-50%-of-personal services requirement and the more-than-750 hours requirement for that business, qualifies as a real estate professional.
Sounds simple, doesn’t it? Not so fast! As you probably guessed, there are a lot of caveats. One of the most notable is that each interest of the taxpayer in rental real estate is treated as a separate activity unless the taxpayer makes the election to treat all interests in rental estate as a single activity. I know you’re thinking, “Huh?”
In Nelson vs. Commr, the Tax Court stated that this rule meant that if a taxpayer owned eight interests in rental real estate (five apartment buildings and three single-family condominiums), and failed to make the election, the taxpayer was required to qualify as a real estate professional for each of those properties separately.
To qualify for all of the properties, the taxpayer would have had to establish that more than one-half of the personal services that she performed during the tax year were performed with respect to each rental property, and that she performed more than 750 hours of services during the tax year on each rental property.
In this case, the taxpayer had a full-time job, not related to her real estate activities, on which she worked 1,800 hours for the tax year. She did not establish that she worked more than 1,800 hours for that year on any of her rental properties, and also did not establish that she worked 750 hours on any of those properties. So, in this case the taxpayer did not qualify as a real estate professional for any of her rental real estate properties.
In another Tax Court case, Hassanipour vs. Commr, a taxpayer owned 28 rental apartments, but failed to establish that he was a real estate professional due to his full-time employment as a research associate for a corporation. At issue was taxpayer’s claim that he spent more time working on the properties than he did on his job.
The court found the taxpayer understated his hours spent as an employee based on time sheets he submitted to his employer, and he overstated the hours spent on the real estate based on a calendar the court found to be neither contemporaneous nor credible. The insufficient hours disqualified him per the IRS real estate professional definition.
Another important and often overlooked rule relates to the personal services performed as an employee. Personal services performed as an employee aren’t treated as performed in real property trades or business, unless the employee is a 5% owner of the employer.
Furthermore, the employee isn’t a 5% owner at all times during the tax year, only the personal services performed during the period the employee is a 5% owner are treated as performed in a real property trade or business.
Here is another example, Carol is a full-time real estate property manager, employed by a corporation in which she owns a 50% interest. This interest satisfies the 5% owner requirement. Moreover, real estate management activities qualify as a real property trade or business. Hence, Carol’s activities as a real estate manager are treated as personal services performed in a real property trade or business.
If Carol owned no interest in the corporation employing her, her activities as a real estate property manager would not be treated as personal services performed in a real property trade or business.
Being a real estate professional brings many wonderful tax benefits. In addition to treating rental real estate losses as non-passive, the overall income from rental real estate will not be subject to the 3.8% tax on investment income.
However, one has to be very careful to first consider how to qualify as a real estate professional and then evaluate their situation. If you’re concerned that you’ll fail either requirement/test and be subject to the 3.8% NIIT or stuck with passive losses, consider increasing your hours so you’ll meet the test. Also be aware that the IRS has successfully challenged claims of real estate professional status in instances where the taxpayer didn’t keep adequate records of time spent. Contemporaneous records aren’t required, but you should at least have appointment books, calendars or narrative summaries that identify the services performed and the approximate amount of hours for each.
If you’re not sure whether you qualify as a real estate professional, please contact us. We can help you make this determination and guide you on how to properly document your hours.
