How to Get the Real Estate Professional Tax Rules Right

Dealing with the Internal Revenue Code is never something easy due to its complexity and numerous rules that sometimes can contradict one another if not grasped properly. Therefore it is very easy to feel confused and sometimes even completely lost when trying to get all of it right. But do not despair, you are not alone in this and even the professionals who establish and enforce the rules don’t always get them entirely right. IRS attorneys and even tax court judges have made plenty of mistakes, which unfortunately cost a number of people quite a lot of money. In this article we will try to explain in a simple language the complicated law related to real estate professionals.

What is a real estate professional

Contrary to the expectations of many, qualifying as a real estate professional is not a straightforward procedure. Or in other words, being just a landlord is not enough. There are several conditions that must be satisfied in order for you to be seen as a real estate professional in the eyes of the IRS and tax courts. And this is important because it allows you to deduct losses from your rental activities and exclude rental income from the 3.8% tax on net investment income that was introduced recently.

The problem, however, arises from the fact that the Section 469 of the tax code, which outlines the conditions for qualifying as real estate professional is very complicated and can easily be misinterpreted or misunderstood. This is exactly what has been happening in tax courts, where many judges have applied the rules in a slightly different way, due to misinterpretation and unfortunately it has had a major effect on taxpayers, causing them to lose money.

Explain it better, Section 469 treats all rental activities as passive, without taking into consideration the level of involvement of the owner. This means that rental losses can only be used to offset other sources of passive income and if there is no such income, the excess losses can’t be deducted at the same financial year, but will be carried forward to future years. However, if you qualify as a real estate professional it would mean that you are someone who truly earns a living this way and therefore should be relieved of rental losses limitations. In order to qualify you will have to pass to quantitative tests:

1. You must spend more time working on your real estate business than any other business or working activity.

2. You must spend a minimum of 750 hours in a tax year on property trades or businesses in which you materially participate. (Essentially this means that if you are a pensioner, spending an average of 400 hours a year as a property manager, you will fail the test and not qualify.

The good news is that “real property trades or businesses includes various activities such as acquisition, development, redevelopment, conversion, operation, management, construction, reconstruction, leasing, brokerage and, of course, rental. You can count the number of hours spent on each activity towards the total minimum of 750.
What is material participation

It is very important to be able to prove that you materially participate in those real property trades and businesses, so there are 7 tests of which you must satisfy at least one.

• You spend more than 500 hours a year participating in the activity.
• Your participation in the activity constitutes substantially all of the participation by all individuals in the activity for the year.
• You spend more than 100 hours a year participating in the activity and no one else spends more hours than you on it.
• The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours.
• You have materially participated in the activity for the past 5 (consecutive or not) years of the last 10 years.
• You have materially participated in a personal service activity for the past 3 (consecutive or not) years preceding the current tax year.
• A generic facts and circumstance tests.
• Combining all the rules we have so far, we can come up with 4 steps to follow and being able to check all of them will give you the title of a real estate professional.
• Participate in a real property trade or business.
• Materially participate in this real property trade or business as defined by one of the 7 tests above.
• The time you spent on the real property trade or business in which you materially participated must be more than the time you spent in any other working activity.
• The time you spent on the real property trade or business in which you materially participate must be more than 750 hours a year.

So far, so good. However, qualifying as a real estate professional does not automatically mean that your rental activities are non-passive. Therefore you still have more to do to prove that you materially participate in your rental activities in order for them to be treated as non-passive. For example, if you clock the required number of hours working on a real estate development activity but also exercise a rental activity and only spend 80 hours a year collecting rent and outsourcing the rest to a property manager, any losses that you acquire will not qualify as non passive.

Where do courts get it wrong

If you only have one rental property, although not very simple, the rules are comprehensible and relatively easy to follow. However, the big mix up occurs when you have multiple rental properties and the court has to decide whether you qualify as a real estate professional. In situations where you own more than one rental property or have several partnership interests, you can group the activities you materially participate in to get the total required number of 500 hours. You can do that in two ways described in Section 469-4 or 469-9. The former allows you to group activities at your own discretion, also known as the “slice and dice” method, which isn’t very effective in helping your losses to qualify as non passive. A more helpful solution would be to use the Section 469-9 election, known as “all or nothing”where you either group all rental activities or none of them. If you elect to group, you can put together all the hours you spend in each rental activity to cover the requirement for material participation. If you don’t make the election you will have to prove that you materially participate in each activity. So with everything that we got so far, the right procedure for establishing whether you are a real estate professional and your losses are passive should look like this:

• Participate in a real property trade or business.
• Materially participate in this real property trade or business as defined by one of the 7 tests above.
• The time you spent on the real property trade or business in which you materially participated must be more than the time you spent in any other working activity.
• The time you spent on the real property trade or business in which you materially participate must be more than 750 hours a year.
• If you have elected Section 469-9 you must materially participate in the grouped activities. If you have not made the election you must materially participate in each activity.

The most common mistake judges and IRS professionals made was to use step 5 to determine whether a taxpayer was a real estate professional, when in reality, the election or non election of Section 469-9 should only be taken into consideration after an individual has qualified as a real estate professional following the first 4 requirements. This small but twisted misinterpretation of the law has caused many people to miss the opportunity to deduct losses, which otherwise would qualify as non passive and therefore deductible.

The silver lining

Although many professionals still get it wrong (let alone ordinary taxpayers), the IRS has finally agreed that there must be a clarification on the law in question and therefore has stated in the CCA 201427016 that the election of Section 469-9 applies only after a taxpayer qualifies as a real estate professional.

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Fulton Abraham Sanchez, the founder of FAS CPA & Consultants of Miami, FL, is a Certified Public Accountant specialized in Tax Planning. You can email him to [email protected].

Contact us [email protected] or call us 786-462-7899 to schedule a confidential consultation.