By Jeffrey G Cohen, CPA
Most people investing and participating in real estate activities probably consider themselves “real estate professionals.” And while that may be true for many reasons, for taxation purposes, the definition is much narrower.
This misconception is very common for taxpayers with rental properties. In general, real estate rental activities are deemed as passive activities and are therefore subject to the 3.8% ACA tax (rental real estate is not subject to self-employment tax). This would subject the owner to passive activity loss carryovers.
If the taxpayer can meet the definition of “real estate professional” under the Internal Revenue Code (IRC), the rental activities can be treated as non-passive and not subject to the 3.8% ACA tax, plus any resulting losses can offset any other taxable income on their personal tax returns.
To qualify as a “real estate professional” for this purpose, the taxpayer must:
- perform more than 50% of personal services in all of the real property trades or businesses in which the taxpayer materially participates, and
- perform more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.
Within this definition are terms and concepts that also need to be defined to understand one’s status as a “real estate professional” under the IRC:
- Real property trade or business – broadly defined to include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage.
- Material participation – only real property trades or businesses in which the taxpayer materially participates are counted for purposes of the 50% and 750-hour tests. Participation in peripheral business activities such as appraiser, mortgage broker or attorney involving real estate transactions does not qualify.
- Grouping of activities – rental real estate activity may not be grouped with any non-rental real estate activity for purposes of determining material participation in that rental real estate activity. The hours spent on the development activity cannot be combined with rental activity to determine material participation in rental activities even though they are closely associated with one of the rental real estate activities.
- Personal services – defined as actual performance of services, including time spent traveling to rental properties. The courts have disallowed a taxpayer’s “on call” and “willing to work” hours to count towards this 750‐hour requirement. Hours spent on investor-related activities (e.g. researching properties) also do not count.
- Real Estate Professional Election
If you meet the definition of “real estate professional” based on the criteria above, you may elect to combine all rental real estate interests in which you had “material participation” (including limited partner interests) as one single activity.
This election can be made in any year the “real estate professional” rules apply. However, once the grouping election is made, it is irrevocable unless there is a material change in the taxpayer’s facts and circumstances. The election is the grouping of real estate activities to avoid 750 hours of material participation in each rental activity. Being on call to work does not count. You must be working approximately 15 hours per week and must have meticulous records. Also, if you are already offsetting passive losses from other activities, you should think twice about the election. Even if you make the election, you must continue to meet the 750-hour rule each year thereafter or you are deemed passive.
The election must be made by the taxpayer to be effective. Simply grouping activities together and reporting the losses as non-passive is not enough. The election must be made on an original return and cannot be made on an amended return.
Before taking this election, the real estate professional should consult with their tax advisor. Certain considerations, such as carryover passive losses, limited partnership interests, income-producing passive activities and rental activities held in pass-through entities, should be considered to determine if the election is the best course of action.
Estate planning considerations must also be part of this review, as gifting into a trust when the grantor has personal passive activity loss carryovers may cause a loss of the tax attributes. Always remember the first rule of tax planning: Ready, Aim, Fire – not Ready, Fire, Aim.
The real estate professional election rules under IRC 469 discussed above should not be confused with the tax on excess net passive income that is imposed under IRC 1375.
Under IRC 1375, if an S corporation has previous C Corp AE&P (accumulated earnings and profits) at the close of the tax year and has more than 25% of its gross receipts from passive investment income in which there is AE&P, there may either be an election to have a deemed taxable dividend of previous C Corp earnings, or the S election may be terminated.
There are many private letter rulings on this. Real estate professional grouping elections treat real estate as non-passive. These elections are entirely different from S elections in which real estate is treated as an active trade or business. Don’t confuse them at your next dinner party.
Jeffrey G. Cohen, CPA is the Tax Services Leader at Grassi Advisors & Accountants