The IRS defines passive activities as:
1. Trade or business activities in which you don’t materially participate during the year.
2. Rental activities, even if you do materially participate in them, unless you’re a real estate professional.
The exception provided in the second definition is a tremendous tax advantage for individuals that meet the requirements of a real estate professional. This is because losses from passive activities can only offset passive income. In years that passive losses exceed passive income, the excess losses must be carried forward and applied against income from passive activities in future years. A real estate professional’s real estate activities are exempt from the general passive activity loss rules and losses resulting from such activities can be used to offset ordinary income.
The tests used by the IRS to determine if an individual qualifies as a real estate professional all revolve around the amount of time spent conducting real estate activities. Recent Tax Court rulings in favor of the IRS should reinforce the importance of having a strong understanding of what constitutes real estate activities and how to properly maintain records of time spent conducting such activities.
Below is a discussion of these recent rulings. For a detailed definition of real estate professional, see section “Real Estate Professional Requirements” below.
Recent Tax Court Rulings
A taxpayer’s rental real estate activities in which they materially participate (defined below) are not subject to limitation under the passive loss rules if: (1) more than half of all personal services performed in a tax year are in real property trades or businesses, and (2) they spend at least 750 hours performing such real property services. A taxpayer can use “any reasonable means” to prove the extent of his or her participation in real estate activities. “Reasonable means” may include identifying of services performed over a period of time and the approximate number of hours spent performing such services by using appointment books, calendars, or other narrative summaries. While IRS regulations do not prescribe specific recordkeeping requirements, they also do not allow a post-event “ballpark guestimate.”
In a recent Tax Court case, Penley v. Commissioner (TC Memo 2017-65), the IRS successfully argued that Penley did not qualify as a real estate professional because he could not properly substantiate his time spent performing real property trade or business. The court found that Penley’s records of time spent on real estate activities were greatly exaggerated because he rounded to the nearest hour or half-hour, did not specify a start or end time, included time spent driving to and from properties, and did not separate out any time for meals or other breaks. Since Penley also had a non-real estate related job, once the court disallowed the majority of the time he claimed was spent on real estate activities, he no longer satisfied the requirement that more than 50% of the individual’s working time must be spent on real estate activities in which the individual materially participates. As a result, all passive losses were disallowed for the tax year in question, and a negligence penalty of 20% was assessed on the underpayment of taxes.
In the Tax Court case, Moss v Commissioner (135 T.C. 365 (2010)), the IRS got another favorable ruling when they argued that Moss did not qualify as a real estate professional because he improperly counted the number of hours spent conducting real estate activities. Moss contended that he satisfied the 750-hour rule by conducting 650 hours of actual real property services, and spending an additional 100 hours “on call” to perform services on the properties he owned. The court rejected Moss’ argument, noting that the language of IRC §469(c)(2)(iii) and Reg. §1.469-9(b)(4) literally required a taxpayer to “perform” the services that are counted toward the 750-hour threshold. Consequently, all passive losses were disallowed for the tax year in question, and an accuracy penalty of 20% was assessed on the underpayment of taxes.
Real Estate Professional Requirements
For an individual to qualify as a real estate professional, three (3) separate tests must be satisfied.
Test #1 (Material Participation) – Individuals satisfy the material participation test for a particular activity by participating throughout the year on a regular, continuous, and substantial basis. This can be demonstrated by meeting one of the following seven tests:
- The taxpayer participates in the activity for more than 500 hours during the year.
- The taxpayer’s participation in the activity for the tax year constitutes substantially all of the participation in the activity of all individuals (including individuals who are not owners of interests in the activity) for the year.
- The taxpayer participates in the activity for more than 100 hours during the tax year, and that participation is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year.
- The activity is a significant participation activity for the tax year, and the taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours. A significant participation activity is a trade or business activity in which the taxpayer participates for more than 100 hours during the tax year, but would not be treated as materially participating if not for the significant participation standard.
- The taxpayer materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately preceded the tax year at issue.
- The activity is a personal service activity and the taxpayer materially participated in it for any three tax years (whether or not consecutive) preceding the tax year at issue.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the year.
Test #2 (750 Hours) – Individuals must spend at least 750 hours per year in real property trades or businesses in which they materially participate. Qualifying real property trades or businesses include property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
- Personal services performed as an employee are not treated as performed in real property trades or businesses unless the employee owns five percent or more of the employer entity.
Test #3 (More Than 50% of Time) – More than 50% of the individual’s working time must be spent on real estate activities in which the individual materially participates.
By staying abreast of the latest real estate industry trends and issues, HLB Gross Collins, P.C. specialists are known for deep understanding of the ever changing, complex regulations our clients are facing. Please do not hesitate to contact us for additional information.
Taxpayers that conduct real property trade or business and qualify as a real estate professional are exempt from the general passive activity loss rules. This is beneficial because losses resulting from such activities can be used to offset ordinary income. Recent Tax Court Rulings in favor of the IRS highlight the importance of properly maintaining records of time spent conducting real estate activities. Additionally, it is critical that time records accurately count only time spent actually performing real property services rather than “ballpark guestimates” that could include time spent traveling and meal breaks.