Real estate professional - rentals & flipping

[Jim S.]

I've been reading old posts about the "real estate professional" status (of which there are many) but it isn't clear to me if flippers can utilize losses from their rental properties if they don't self-manage their properties (which would help them accrue "material participation" in the rentals).

I currently work a W-2 job and have 17 rental units which generate a decent amount of paper losses each year via depreciation. I am considering moving into either home or land flipping full-time after I hit 40 units of rental property. I'd like to have my rentals help offset the huge tax liability that flipping generates.

The Scenario:

Let's say that I work 2,500 hours per year flipping land and therefore qualify as a RE Professional and make $150k/yr from flipping. I have 100 rental units which generate $100k/year in losses thanks to depreciation. All of the units are out of state and as a result are managed by third party managers, but I have >10% stake and any purchase decisions >$500 are run through me so I have met "active participation" but not "material participation" in the rental business as I spend less than 500 hours on the activity. 

Can I "group" my flipping & rental activities such that I have now "materially participated" in the combined activity, allowing me to utilize the $100k in losses to turn my $150k self-employment income into $50k?

For the record I will certainly hire a CPA when I get near this situation, but for now I'm just trying to wrap my head around my options 2-3 years out. If I can shield a large portion of my income then it would make help make the argument to quit my W-2 job sooner and move into full-time real estate work. Thanks in advance for any replies!

[Ashish Acharya]

Originally posted by @Jim S.:

I've been reading old posts about the "real estate professional" status (of which there are many) but it isn't clear to me if flippers can utilize losses from their rental properties if they don't self-manage their properties (which would help them accrue "material participation" in the rentals).

I currently work a W-2 job and have 17 rental units which generate a decent amount of paper losses each year via depreciation. I am considering moving into either home or land flipping full-time after I hit 40 units of rental property. I'd like to have my rentals help offset the huge tax liability that flipping generates.

The Scenario:

Let's say that I work 2,500 hours per year flipping land and therefore qualify as a RE Professional and make $150k/yr from flipping. I have 100 rental units which generate $100k/year in losses thanks to depreciation. All of the units are out of state and as a result are managed by third party managers, but I have >10% stake and any purchase decisions >$500 are run through me so I have met "active participation" but not "material participation" in the rental business as I spend less than 500 hours on the activity. 

Can I "group" my flipping & rental activities such that I have now "materially participated" in the combined activity, allowing me to utilize the $100k in losses to turn my $150k self-employment income into $50k?

For the record I will certainly hire a CPA when I get near this situation, but for now I'm just trying to wrap my head around my options 2-3 years out. If I can shield a large portion of my income then it would make help make the argument to quit my W-2 job sooner and move into full-time real estate work. Thanks in advance for any replies!

 This is one of the complicated areas. 

1) You can group rental with Flip to see if you qualify as RE pro. This is not needed for you as you meet 750 with just flipping. 
2) Once you are a RE pro, you have to materially participate in the property to deduct the losses. 

A real estate professional may not group a rental real estate activity with any non rental real estate activity for purposes of determining material participation in that rental real estate activity [Reg. 1.469-9(e)(3)]. When determining material participation in rental real estate activities, each interest of the taxpayer in a rental real estate activity is treated as a separate activity [IRC Sec. 469(c)(7)(A)(ii)]. The taxpayer can elect to treat all interests in rental real estate activities as a single activity 
With that, the 500 hours is not that challenging. On top of that, the "500hr" is not the only factor that determines material participation. There are seven tests. See below- 

• 1. More Than 500 Hours Test. The taxpayer participates in the activity for more than 500 hours during the year. NOTE: this is not annualized.
• 2. Substantially All Participation Test. The taxpayer's participation in the activity constitutes substantially all of the participation by all individuals (including nonowners) in the activity for the year.
• 3. More Than 100 Hours Test. The taxpayer's participation is more than 100 hours during the year, and no other individual (including nonowners) participates more hours than the taxpayer. 
• 4. Significant Participation Activity (SPA) Test. The activity is a significant participation activity in which the taxpayer participates for more than 100 hours during the year and the taxpayer's annual participation in all significant participation activities is more than 500 hours. [A significant participation activity is generally a trade or business activity (other than a rental activity) that the taxpayer participates in for more than 100 hours during the year but does not materially participate (under any of the material participation tests other than this test).]  Eg: Charles owns interests in a restaurant, a shoe store and an orange grove. Each of these ventures has several full-time employees. As of Oct. 31, Charles has worked 200 hours in the restaurant, 200 hours in the shoe store, and 75 hours in the orange grove. If by the end of the year he puts in another 26 hours in the orange grove, he will have participated more than 500 hours in all his significant participation activities and the material participation standard will be satisfied.

Although the loss from the activity that does not meet SPA rule is passive, the gain might be caterized a non passive. If the taxpayer works fewer than 500 hours in all significant participation activities combined, overall losses from the significant participation activities are passive, but if there is net gain, a portion of the gross income will be recharacterized as nonpassive. In such cases, the net income of each activity with positive net income for the year is multiplied by a fraction: the numerator is the combined net income for all significant participation activities, and the denominator is the combined net income for the activities with positive net income.

Eg: Betty is a full-time teacher, but she also owns stock in two S corporations (Acorp and Beecorp) that pass through income to her. Betty significantly participates in both, performing more than 100 hours annually in each, but she does not participate in either (or both combined) for more than 500 hours. Other shareholders participate to a greater extent than Betty. During the current year, she participated 150 hours in Acorp and 300 hours in Beecorp. Betty is also a partner in a limited partnership that passes through losses, but she does not participate at all in that activity. Can the limited partnership losses be offset against S corporation income?

Betty significantly participates in each S corporation. Therefore, the income is recharacterized as nonpassive and cannot be offset against the partnership's passive losses.

• 5. Prior-year Material Participation Test. The taxpayer materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years.
• 6. Personal Service Activity Test. For a personal service activity, the taxpayer materially participated for any three tax years (whether or not consecutive) preceding the current tax year. (Personal service includes the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.)
• 7. Facts and Circumstance Test. Based on all the facts and circumstances, the taxpayer participates on a regular, continuous, and substantial basis during the year [Temp. Reg. 1.469-5T(a)(7)]. Future regulations are to provide further guidance for this test. However, temporary regulations indicate that if an individual participates in an activity for 100 hours or less during the year, this “facts and circumstances” test is not available. Participating in the management of an activity is not considered for this test if (a) any person (other than the taxpayer) received compensation for performing services in the management of the activity, or (b) any individual spent more hours during the tax year performing management services than the taxpayer (whether or not the individual was compensated for the management services).