10.3 Real Estate Professionals

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).

Test 1: Qualifying as a real estate professional.

You must meet both of the following two activity tests for the tax year:

1. More than 50% of your personal services in all of your businesses must be performed in real property businesses in which you materially participate (10.6). For this purpose, a real property business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, or brokerage trade or business. Real estate financing is not included. Personal services performed as an employee are not treated as performed in a real estate business unless you are considered a “more than 5% owner” in the employer. That is, you must own more than 5% of the outstanding stock or more than 5% of total combined voting powers of all stock issued by the corporation. In a noncorporate employer such as a partnership, you must own more than a 5% capital or profit interest.
2. More than 750 hours of your services are in real property businesses in which you materially participate (10.6).
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image Planning Reminder
Tax Break for Real Estate Professionals
Proving professional status and material participation allows you to avoid passive loss limitations. You may improve your ability to meet the material participation tests in 10.6 by aggregating your rental real estate activities. However, you may not want to aggregate activities if you have passive losses from non–real estate activities and have rental income from an operation that, if treated as passive income, could be offset by the losses.
Also be aware that if you elect to group all of your rental real estate activities as one activity and later sell one of the rental properties, you will probably be unable to deduct suspended losses from that property because of the rule that requires “substantially all” of your interest in an activity (here, the combined activity) to be disposed of in order to deduct suspended losses (10.13).
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In one case, a taxpayer claimed that when he was not at his full-time job he was “on call” for working on his four rental properties because he could have been called to do work at any time on the properties, and he argued that the “on call” hours should count towards the 750-hour test. Without the “on call” hours, he could substantiate only 645.5 hours of work on the rentals. The Tax Court held that even if the taxpayer was “on call,” on call hours do not count towards the 750-hour test, since the law requires that the taxpayer actually perform over 750 hours of service.
For purposes of determining hours of material participation under (1) and (2) above, each interest in rental real estate property is treated as a separate activity unless you elect to treat all of your interests as one rental activity as discussed below. If, under the rules in 10.1, you group a rental real estate activity with a business activity, that rental activity is not treated as rental real estate for purposes of the real estate professional rules.

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).

Test 2: Rental real estate activity material participation.

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.

Election to aggregate rental real estate activities.

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.

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image Caution
Consistent Treatment Required
Once you treat activities separately or group them together as a single activity, the IRS generally requires you to continue the same treatment in later taxable years. You can regroup activities only if the original treatment was “clearly inappropriate” or has become clearly inappropriate because of a material change in circumstances.
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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.

Late elections.

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.

EXAMPLE
Kosonen owned seven rental properties. In 1994, he worked on all his properties a total of 877 hours, which qualified him as a real estate professional. But he could not meet the material participation test for each of the individual properties. If he could aggregate the activities, the material participation test would be met for the combined activity, which would be treated as nonpassive, allowing him to deduct his net rental losses against nonpassive income.
On his 1994 return, he reported the losses from all the activities as an aggregate deduction and treated it as nonpassive. The IRS disallowed the deduction because he had not made a specific election to aggregate. Kosonen argued that by claiming on his return the total of his losses, he had put the IRS on notice that he was aggregating his rental activities.
The Tax Court disagreed. A specific election is required to put the IRS on notice that a taxpayer is a qualifying real estate professional making the election to aggregate rental activities. Reporting the net losses on his return as an aggregate active (nonpassive) loss was not enough because Kosonen could also have reported his net losses as active if he had materially participated in each of the seven activities and had not elected to aggregate.

Rental loss allowance may apply to nonqualifying rental activity.

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.

EXAMPLE
Jane Morton owns a rental building in Manhattan and a rental building in Newark. In 2012, she qualifies as a real estate professional. She does not elect to treat the two buildings as one activity. She materially participates in the operations of the Manhattan building, which has $100,000 of disallowed passive losses from prior years and a $20,000 loss for 2012. She does not materially participate in the operation of the Newark building, which has $40,000 of rental income for 2012. Jane also has $50,000 of 2012 income from other nonpassive sources.
Because Jane materially participates in operating the Manhattan building, the $20,000 loss from the building for 2012 is treated as nonpassive and offsets $20,000 of the $50,000 nonpassive income from other sources.
Jane can also use $40,000 of the $100,000 prior year suspended losses from the Manhattan building to offset the $40,000 of passive rental income from the Newark building in 2012. Of the $60,000 remaining suspended loss, $25,000 may be deducted under the rental loss allowance provided Jane’s MAGI is under $100,000, the phase-out threshold for the allowance (10.2).
The rental loss allowance is deducted from the $30,000 of remaining nonpassive income ($50,000 − $20,000), leaving Jane with $5,000 of nonpassive income for 2012. The balance of suspended losses of $35,000 ($60,000 − $25,000 rental allowance) may be carried forward and used in 2013 to offset income from the Newark building or passive income from other sources.

Interests in S corporations and partnerships.

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.

Limited partners.

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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