Syndication losses against active income

[Michael Plaks]

Posting my response to a client's question, in order to get my colleagues input on this issue.

Q: I have an investor who is actively investing in real estate on their own & have no f/t job. So spending enough time in the industry to claim the "active RE pro" status on the tax return. Can they claim their income/loss from syndications where they invest as LP against their active income? 

A: I despise the word "syndication." :)  It recently became as meaningless as "business" or "investment." 200 people contributing $50k each for a large commercial deal is called syndication, and so is 3 friends putting $10k apiece as a down payment for a duplex. This distinction matters.

For tax purposes, there's a concept of active participation. It basically means participating in management decisions, such as approving tenants or lease terms, approving capital improvements and contractors, and so on. This is likely to be a yes in a 3-people scenario and likely to be a no in a 200-people scenario. 

Another requirement for active participation is owning at least a 10% interest - which again eliminates large syndications.

The third requirement for active participation is to not be a limited partner. In case of an LP it's a deal-breaker. If it was an LLC, as opposed to an LP, then there is significant controversy as to whether or not LLC members are treated as limited partners.

Now, to your question.

Without active participation (which is your case), passive losses from syndication can only offset passive income. So, if your client has some positive income (including capital gains) from his personal investments - he may not want to claim RE Pro status and use these gains against his K1 losses.

If he manages to qualify for active participation (a small syndication via an LLC, case by case) - then his K1 losses may offset his other income, up to $25k, as long as his income is under $100k. This $25k window is phased out between $100k and $150k income and then disappears.

PS. This is why we accountants have job security.

[John Woodrich]

@Michael Plaks I didn't read the above commentary and only put 5 minutes into this. Here is what I found in the Federal Tax Coordinator:

¶M-5004. Material participation by real estate professionals in rental real estate activities through limited partnerships.

With certain exceptions, all rental activities are automatically treated as passive activities, regardless of whether a taxpayer materially participates in the activity. See ¶ M-5101 et seq. Under one of the exceptions, the rental real estate activities of real estate professionals (as defined at ¶ M-5168 et seq.) aren't automatically treated as passive activities. As a result, if a real estate professional materially participates in a rental real estate activity, that activity is treated as not a passive activity. See ¶ M-5161 et seq. For purposes of this exception, a taxpayer may elect to aggregate all rental real estate interests and treat them as a single activity. See ¶ M-5163 et seq.

However, the above rules don't affect the determination of whether a taxpayer materially participates with respect to any interest in a limited partnership as a limited partner. 15 Moreover, the election to aggregate all rental real estate interests isn't intended to alter the rules relating to the material participation of a limited partner. 16

RIA observation: In other words, the fact that a real estate professional's rental real estate activities (whether aggregated or not), conducted through limited partnership interests, aren't automatically treated as passive activities, under the rules explained at ¶ M-5161 et seq., doesn't mean that those activities are automatically treated as non-passive. For those activities to be treated as non-passive, the taxpayer must pass one of the material participation tests allowed to limited partners that's discussed at ¶ M-5003. Otherwise, the activity will be treated as passive.

If a taxpayer makes the election to treat all interests in rental real estate as a single rental real estate activity, and at least one interest in rental real estate is held by the taxpayer as a limited partnership interest (as defined at ¶ M-5002 and ¶ M-5003), the combined rental real estate activity is treated as a limited partnership interest of the taxpayer for purposes of determining material participation. Accordingly, the taxpayer won't be treated as materially participating in the combined rental real estate activity unless the taxpayer satisfies one of the material participation tests allowed to limited partners that's discussed at ¶ M-500317 Thus, a real estate professional must establish material participation in a rental real estate activity held, in whole or in part, by a limited partnership interest under one of the tests that apply to determine the material participation of limited partners. 18

If a real estate professional makes the election to treat all interests in rental real estate activities as a single rental real estate activity (see ¶ M-5163 et seq.), and the taxpayer's share of gross rental income from all of the taxpayer's limited partnership interests in rental real estate is less than 10% of the taxpayer's share of gross rental income from all of the taxpayer's interests in rental real estate for the tax year, the rule discussed at footnote 17 doesn't apply. In this case, the taxpayer may determine material participation under any of the tests discussed at ¶ M-490519

15 Code Sec. 469(c)(7)(A)

16 H Rept No. 103-111 (PL 103-66) p. 614

17 Reg § 1.469-9(f)(1)

18 Preamble to , 01/10/95.

19 Reg § 1.469-9(f)(2).