Explained: RE Professional & K-1 syndications

[Michael Plaks]

Before we start...  This post focuses on one highly technical issue related to syndicated investments: taking K-1 losses while being a Real Estate professional. I recommend you first read my earlier post on the overall tax consequences of K-1s from syndications: https://www.biggerpockets.com/...

1. What is the REP status and why bother?

Doctors, engineers, and other high-income earners like passive investing in the syndications that acquire rental real estate such as apartments and commercial buildings. These syndicated investments usually produce tax losses, except for the final year when they sell the property. Tax losses are reported on Forms K-1.

So you hope to take these losses from K-1 syndications and apply them against your high W2 income, to reduce your overall taxes. Unfortunately it is normally prohibited by the tax law if your income is high enough. You do have losses, but you cannot take them until the property is sold by the syndication. It's quite frustrating.

One popular and completely legal loophole is to have a spouse who would qualify as a Real Estate Professional. If you don't have a full-time W2 job and do mostly real estate, you might even be able to qualify for this status yourself. Qualifying for the REP status is complicated and is not the topic of this post. You can find several blog posts and podcasts here on BiggerPockets that explain the REP status. For the purposes of this post, I will mention just two of the REP conditions:

1. you need to spend 750 hours per year working on your real estate projects and
2. you need to "materially participate" in these real estate projects

2. What is "material participation"?

This is also a very complicated topic, but basically you need to meet one of the 7 tests set by the tax law: https://www.irs.gov/publicatio... Out of these 7 tests, the first three are the most common ones. Using a layman's translation from the tax law jargon, here're those 3 key tests:

1. You work 500 hours on the project or
2. You do pretty much everything yourself or
3. You work 100 hours on the project, and nobody else works more hours than you do on this same project

Each project that you want to include into the REP status must pass one of these three tests (or one of the remaining four tests that are even more difficult to pass.) 

If you have no other real estate investments but syndications, you cannot meet any of the 7 material participation tests. As a result, you cannot be a Real Estate Professional if all of your investments are passive investments in syndications.

3. What if you're already a REP from other real estate projects?

You (or your spouse) could qualify for the REP status via managing your own rental properties, by doing wholesaling, flipping or construction or by working as a Realtor. Can't you just throw your syndications into the same basket?

Not so fast! Most investors believe that, once they qualify for the REP status, they can deduct any and all of their real estate losses. They forget about that pesky material participation test. You can only take losses from the real estate projects that do pass material participation.

For example, if you're a full-time Realtor working 2,000+ hours as an agent, you easily qualify for REP. However, if you invest in a syndication, you still cannot take its losses UNLESS your syndication investment passes material participation. And I already explained that K-1 syndications can't do that. At least not on their own. 

4. Election to aggregate

The tax law provides a loophole: it allows you to aggregate all your rental activities. What it means is that you can combine all your rental real estate into one group and count total hours between all of your properties. For example, if you spend only 10 hours a year per property, but you have 10 properties - voila, you now have the 100 total hours necessary for the test #3 of material participation! As long as no other person spends more than 100 hours working on your properties, you win the game.

Why is this election so important for syndications? Because, while syndications cannot pass material participation test themselves, if we combine them with the rental properties that you own yourself, then material participation test applies to the combined group as a whole.

And that should be easy. In my example above, we already have 100 hours from our 10 rental houses, so we already passed test #3! Our syndication, despite having only 5 hours of participation, gets a free piggyback ride. Right? Wrong!

5. Contamination problem

Yes, we do have 105 hours now, 5 more than we needed for the test #3. The problem is that those extra 5 hours come from syndications, and they are "bad" hours because you are a limited partner in the syndication. Worse, the 5 "bad" hours from our syndication contaminate the 100 "good" hours from our personal rentals. What we have now is 105 "bad" hours. 

The IRS punishment for having these "bad" hours is restricting which of the 7 tests we can use. Only three of the seven tests remain available. Unfortunately, tests #2 and #3 are no longer allowed. We're stuck with test #1. 

6. First lifeline: 500 hours

But we still have this test #1. If we can show 500 qualified hours between all of our rental properties - we're good to go! We can take all our syndication losses and apply them against any income, including our W2 income. Yay!

Two important points to keep in mind:

• we can only count hours related to our rental properties, both owned directly and via syndications. We cannot count Realtor hours, wholesaling hours or flipping hours towards this 500 hours threshold
• we can only count qualified hours. Details are beyond this post, but to illustrate this requirement, hours spent watching BiggerPockets podcasts do not count

7. Second lifeline: de minimis exception

The IRS forgives your contamination as long as your syndications income is relatively small. Specifically, if your gross rent from your syndications is no more than 10% of your total rents from everything, including your personal properties. 

The biggest challenge here is getting the data for this test. You need to know your share of the syndication's gross rent income, before expenses. Your K-1 does not include this information. You either need to have a copy of the syndication's tax return or their profit and loss (P&L) statement or otherwise get this information from the syndication's bookkeeper or CPA.

It only works if you have significant rents outside of your syndications, and your share of the syndication's rents is small in comparison, under 10% of the total rent across all of your holdings.

8. Third lifeline: sponsors and general partners

If you're not just a passive investor but are also the syndication's sponsor, manager, general partner or are otherwise involved in the day-to-day operation of the syndication, then you're in the special privileged group. You can use any of the 7 tests to establish material participation.

9. Fourth lifeline: fighting the IRS over their treatment of LLCs

The contamination problem is based on you being a limited partner. This term has a specific legal meaning which depends both on the federal tax law and state business law. If your syndication is organized as an LLC, and most of them are, the IRS will treat you as a limited partner. They are pretty adamant about it and train their auditors accordingly.

However, there's some grey area around this issue. The law and the courts' interpretation of the law give us some wiggle room if you have some involvement in the syndication other than just giving them your money. Depending on your specific situation, you might be able to shed the limited partner label that the IRS wants to tag you with. The details are too tedious, but if you're itching to get confused, read this thread: https://www.biggerpockets.com/...

Just remember that this means picking a fight with the IRS, so do your homework first. Better yet, hire a tax professional who has done his.

10. Conclusion

Same conclusion after discussing any complex tax issue: there's a lot more than meets the eye. Hire a good tax professional. We are not cheap, but it's for a reason: "saving" on professional advice can end up costing you a lot more.