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THE PASSIVE LOSS RULES AND REAL ESTATE PROFESSIONALS- DEDUCTING REAL ESTATE LOSSES AGAINST ORDINARY INCOME | By: Multiple Speaker(s)


REAL ESTATE PROFESSIONAL
 
THE PASSIVE LOSS RULES AND REAL ESTATE PROFESSIONALS-
DEDUCTING REAL ESTATE LOSSES AGAINST ORDINARY INCOME
By Chuck Vonderhaar, CPA
 
 Passive loss rules don’t apply to real estate professionals. A taxpayer’s rental real estate activities in which he or she materially participates are not subject to limitation under the passive loss rules if the taxpayer meets eligibility requirements relating to real property trades or businesses in which the taxpayer performs services. This means that real estate investors who qualify are permitted to deduct their rental real estate losses against other income sources (e.g., commissions, wages, etc.).
 
An individual satisfies the real estate professional eligibility requirements when two requirements are met.
1. The 50% test. More than 50% of the individual’s personal services during the tax year must be performed in real property trades or businesses (defined below) in which the individual materially participates (defined below), and
2. The 750 hour test. The individual must perform more than 750 hours of service in those same trades or businesses.
 
It’s a time test that requires proof. The total time spent in any combination real estate related activities (see list below) is used to determine if both the 50% and the 750 hour tests are met.
 
Note: A number of Tax Courts are getting this requirement wrong. Real estate professionals must prove that more than 750 hours (and more than 50%) is spent in ALL real estate businesses, not more than 750 hours in each real estate activity.
 
3. The real estate businesses that can be combined. Real property trade or business means “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business”.
 
Planning tip. According to this passive loss relief provision, the “blessed” businesses generally include most (1) real estate builders and contractors, (2) owners of rentals, (3) property managers and (4) participants in the real estate brokerage business-if they meet the 50% participation and the 750-hour requirements. Real estate appraisers and loan brokers are excluded from receiving this tax treatment.
 
Planning point. Any hourly combination in these four “blessed” businesses is permitted. For example, a taxpayer who spends 100 hours managing rentals and 651 hours selling real estate exceeds the 750-hour minimum.
 
Only one spouse needs to be the real estate professional. In the case of a joint return, the foregoing requirements for qualification as a real estate professional are satisfied if, and only if, either spouse separately satisfies the requirements. If either spouse qualifies as a real estate professional, the rental activities of the real estate professional are not passive. Instead, the real estate professional’s rental activities would be governed by the trade or business passive activity criteria.
 
Required work for the 50%/750 hour test is different than the required work for material participation. With two restrictions, participation is any work done by an individual in any capacity, management or operations, in connection with any activity in which the individual owns an interest.
 
Restriction for employees. When the eligibility test is applied, the personal services of an employee are not counted unless the employee is also at least a 5% owner.
 
Substantiation of time requirement. With respect to the evidence that may be used to establish hours of participation, the extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
 
Material participation. After determining if the taxpayer is a real estate professional, the real estate professional must prove he or she materially participated in managing the real estate rentals. This is again a time test, but different-and more restrictive-than the 50%/750 hour test. An individual is treated as participating “materially” for the taxable year if the individual’s participation meets one of the seven enumerated material participation tests. The three most common ways that real estate investors meet this “material participation” test are by:
 
1. Managing and operating the rental real estate activity for more than 500 hours during the year,
2. Doing substantially all the work required to manage and operate the rental real estate during the year (probably more than 70% of the total business hours are performed by the landlord) or
3. Working more than 100 hours during the year with no one (including nonowner employees and independent property managers) participating more than the landlord.
 
Owner can “tack” spouse’s time. Any participation by one spouse is attributed to the other spouse, even if no joint return is filed and/or the participating spouse had no ownership interest in the activity. In effect, therefore, material participant status of both spouses is determined as though the two spouses were one individual.
 
When management does not count-only counting the money. If the total amount of the taxpayer’s involvement is studying and reviewing financial statements, preparing or compiling summaries or analyses of the finances or operations of the activity in a nonmanagerial capacity, this management time is ignored.
 
 
The Real Estate Business That Can be Combined
 
As mentioned previously, real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
 
Real estate “agent” is in the real estate brokerage business. Despite an ongoing position by IRS auditors that only someone holding a real estate broker’s license may be considered in a “real estate brokerage or business”, the Tax Court held that married taxpayers qualified to deduct losses from rental real estate activities in which they materially participated based upon the wife’s occupation as a real estate agent (as a salesperson and not a broker).
 

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