Real estate rental activities are automatically passive (10.1) for all taxpayers except qualifying real estate professionals. You qualify as a real estate professional if you meet both parts of Test 1 below. If you qualify, any rental real estate activity in which you materially participate (Test 2) is not a passive activity. Income or loss from the rental real estate is reported as nonpassive on Schedule E (Form 1040).
You must meet both of the following two activity tests for the tax year:
Attorneys who specialize in real estate practice while participating in a rental business may not treat the legal practice as material participation for purposes of qualifying as real estate professionals.
For a married couple filing jointly, both the “50% of services test” and the “750 hours test” must be met by one of the spouses individually, without regard to the other spouse’s services.
A closely held C corporation qualifies under the real estate professional rules if in a taxable year more than 50% of the gross receipts of the corporation are from a real property business in which the corporation materially participates (10.15).
If you qualify as a real estate professional under Test 1 above, you must still show that you materially participate (10.6) in your rental real estate activity(ies) to avoid passive activity treatment. If you have more than one rental real estate activity and elect to aggregate (see below), total participation in all of the activities is combined in applying the material participation tests in 10.6. If an election to aggregate has not been made, material participation must be determined separately for each rental property.
For purposes of Test 2 (rental real estate material participation), you may elect to aggregate all of your rental real estate activities for any year you qualify under Test 1 as a real estate professional. You elect to aggregate by attaching a statement to your original tax return for the year. The required election statement must contain a declaration that you are a qualifying real estate professional and are treating all of your rental real estate activities as a single activity under Internal Revenue Code Section 469(c)(7)(A). The election is binding for all future years in which you qualify as a real estate professional, even if there are intervening years in which you do not qualify. In the nonqualifying years, the election has no effect. You may not revoke the election in a later year unless there has been a material change in circumstances that you explain in a statement attached to your original return for the year of revocation. That the election no longer gives you a tax advantage is not a basis for a revocation.
If the election to aggregate is made and there is net income for the aggregated activity, the income may be offset by prior-year suspended losses from any of the aggregated rental real estate activities regardless of which of the rental activities produced the income.
Prior to the release of Revenue Procedure 2011-34, taxpayers who did not make the aggregation election on their original return and who wanted to make a late election had to incur the expense of asking the IRS for a private letter ruling and show that the failure to make a timely election was inadvertent. Under Revenue Procedure 2011-34, you may make a late election on an amended return if you (1) had reasonable cause for not meeting the original deadline; (2) took positions on your tax returns as if the election to aggregate had been timely made—consistent filing is required for all years including and following the year the requested aggregation is to be effective; and (3) timely filed all the returns that would have been affected by the election had it been timely made. Returns filed within six months of the original due date (without extensions) are treated as timely filed for this purpose.
If you meet tests 1–3, you should attach a statement to an amended return for the most recent tax year and mail it to the IRS service center where your current year return will be filed. The statement must include the required aggregation declaration that you are a qualified real estate professional and are making the election to aggregate pursuant to Code Section 469(c)(7)(A). It must also declare that tests 1–3 have been met and explain what the reasonable cause was for not making a timely election. The statement must be dated and signed under penalties of perjury. At the top, write “FILED PURSUANT TO REV. PROC. 2011-34.” Even if the IRS grants relief to make the late election, the IRS can later challenge whether you met the real estate professional and material participation tests, or whether the eligibility requirements of Revenue Procedure 2011-34 were met.
A real estate professional may also be able to claim all or part of the $25,000 rental loss allowance (10.2). For example, you are a real estate professional and meet the material participation test for one rental real estate activity but not for another and do not elect to aggregate. Losses from the nonqualifying activity can qualify for the rental allowance. Furthermore, suspended prior year losses from the qualifying activity may also be deductible under the rental loss allowance, as illustrated in the following Example.
Your interest in rental real estate held by a partnership or an S corporation is treated as a single interest in rental real estate if the entity grouped its rental real estate as one rental activity. If not, each rental real estate activity of the entity is treated as a separate interest in rental real estate. However, you may elect to treat all interests in rental real estate, including the rental real estate interests held by an S corporation or partnership, as a single rental real estate activity.
If you hold a 50% or greater interest in the capital, income, gain, loss, deduction, or credit in a partnership or S corporation for the taxable year, each interest in rental real estate held by the entity is treated as a separate interest in rental real estate, regardless of the entity’s grouping of activities. However, you may elect to treat all interests in rental real estate, including your share of the rental real estate interests held by the entities, as a single rental real estate activity.
Generally, a person who has a limited partnership interest (10.11) in rental real estate must establish material participation by participating for more than 500 hours during the year (Test 1 in 10.6) or meeting Test 5 or Test 6 in 10.6. These material participation tests also generally apply if an election is made to aggregate limited partnership interests in rental real estate with other rental real estate interests. However, under a de minimis exception, these more stringent rules may be avoided if the election to aggregate is made and less than 10% of the gross rental income for the taxable year from all rental real estate activities is attributed to limited partnership interests. In such a case, you may make the election to aggregate all rental real estate activities and determine material participation for the aggregated activity under any of the seven material participation tests (10.6).
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