Tax Geek Tuesday(?): The IRS Finally Figures Out The Real Estate Professional Rules
When you earn your living dealing with something as expansive and complicated as the Internal Revenue Code, it’s pretty damn easy to feel inadequate. To fear that you haven’t seen enough of the tax law. Or that the parts you have seen, you don’t fully understand. To worry that everyone on the other side of a meeting table or conference call knows far more than you do. But work and worry long enough, and one day you’ll wake up and realize that nobody knows this stuff. I say this not to disparage, but to encourage. Because the sooner you learn that the smartest people in the tax world--from Big 4 partners to IRS attorneys to Tax Court judges—can and do misinterpret the law with alarming regularity, you’ll stop beating yourself up when you struggle to figure out when to deduct your client’s accrued pension expense. Case in point: the law surrounding “real estate professionals”. As we’ll discuss more fully below, qualifying as a real estate professional has long been a boon to taxpayers who would otherwise be limited in the losses they could deduct from rental activities. More recently, meeting the standards of a real estate professional became important even when a taxpayer generates net rental income, because only real estate professionals can exclude rental income from the new 3.8% tax on net investment income, as this prior column discusses in excruciating detail. Despite encompassing only a few short paragraphs in Section 469, the real estate professional rules have been heavily litigated, and for some reason that defies explanation, I’ve read pretty much every case decided on the issue. On more than a few occasions, I’ve read the published opinions of Tax Court judges on Section 469 and questioned, “that’s not really what the law says, is it?” Now typically, when I feel this way while analyzing a decision, my skepticism can be attributed to the pedestrian reading comprehension skills that rendered me unsuitable for all but the shadiest law schools. But with regards to the real estate professional rules, I really believed that I was on to something. And it turned out I was right. So what’s the issue? Section 469 is a tangle of rules. While no one rule, standing on its own, is particularly troublesome, it always appeared to me that the IRS and the courts misunderstood how to fit them all together. Under the general rule of Section 469, all rental activities are treated as passive, regardless of the individual owner’s extent of participation. As a result, rental losses can only be used to offset other sources of passive income. If the owner doesn’t have any passive income—or enough to fully offset the losses--the excess losses cannot be used currently, and instead are carried forward to future years. An exception is carved out, however, for so-called “real estate professionals,” the idea being that someone who truly earns their living in real estate trades or businesses should be free to use rental losses without limitation. Quantitative Tests To ensure that the benefit of the exception is preserved for those who truly deserve it, Section 469(c)(7) requires that two quantitative tests be satisfied in order for a taxpayer to qualify as a real estate professional. Here are the tests, with my plain English definition in the parenthetical: 1. More than one-half of the personal services you perform in all trades or businesses for the tax year must be performed in real property trades or businesses in which you materially participate (you must spend more hours on real estate activities than non-real estate activities, to prove that you earn your living in the real estate world), and 2. You must perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate. (This minimum-hour requirement prevents a retiree who spends 400 hours a year managing a rental property from qualifying). Real Property Trades or Businesses Very important to this discussion is the fact that the term “real property trades or businesses” encompasses far more than simply the rental of property; in fact, the statute lists nearly a dozen activities that constitute a real property trade or business, including development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. Thus, you do not have to be a landlord to be a real estate professional, a fact that plays a huge role in the ongoing struggle many experts have in deconstructing Section 469, and one I will address again shortly when we tie this all together. Material Participation You may have noticed that both quantitative tests hinge on your “material participation” in the real property trade or business. For this standard, we turn our attention to Reg. Section 1.469-5T, which provides seven ways in which you can establish that you materially participate in a trade or business: 1. You participate in the activity for more than 500 hours during the year, 2. Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year, 3. Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than the taxpayer, 4. 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. [A significant participation activity is generally a trade or business activity (other than a rental activity) that you participate in for more than 100 hours during the year but do not materially participate in (under any of the material participation tests other than this test),] 5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years, 6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or 7. A generic facts and circumstances test. Let’s put together what we have so far. In order to qualify as a real estate professional, you must: 1. Participate in a real property trade or business as defined by the statute. 2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. 3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job. 4. The time spent participating in real property trades or businesses—but only those real property trades or business in which you materially participate—must exceed 750 hours. Knock those four tests out, and you’re a real estate professional. By way of example: A owns one large commercial building. He rents the building to 40 different tenants. A spends 2,000 hours managing and maintaining the building for the year, and it is A’s only job. The building kicks off a $400,000 rental loss. Is A a real estate professional permitted to use the loss in full without limitation? Here, the determination is fairly painless. We simply run through our four tests: 1. Does A participate in a real property trade or business as defined by the statute? Sure does…rental and leasing are listed as real property trades or businesses. 2. Does A materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. Yes. A spends 2,000 hours in the activity, which is more than the 500 hours necessary to satisfy test #1. 3. Does the time spent participating in real property trades or businesses—but only those real property trades or businesses in which the A materially participates—exceed the time you spend in non-real property trades or businesses; i.e., your day job? Yes. A spends 2,000 hours on real property trades businesses in which he materially participates, and none on non-real property trades or businesses. 4. Does the time spent participating in real property trades or businesses—but only those real property trades or business in which A materially participate—exceed 750 hours? Yes. He spends 2,000 hours participating in a real property trade or business in which he materially participates, and the last time I checked, 2,000 is more than 750. So our guy A can deduct his rental loss in full, right? Not so fast. What many people don’t realize—though this is not the part the courts have consistently gotten wrong—is that satisfying the two quantitative tests and qualifying as a real estate professional does not guarantee that your rental activities are nonpassive. It simply means that your rental activity is not passive regardless of your level of participation. Stated in another manner, qualifying as a real estate professional is simply the first step in the process; it merely buys you the opportunity to prove that you materially participate in your rental activities, and can thus treat them as nonpassive. Let’s go back to our example. A clearly qualifies as a real estate professional. But that is merely the first step. Next, A has to establish that he materially participates in his rental activity. For A, this easy; he spent 2,000 hour on his one rental activity, so he materially participates by any measure of the -5T regulations. But what if we switch the facts a bit? Assume A spent 2,000 hours in the real estate trade or business of construction, and owned one rental property on which he spent only 50 hours collecting rent checks throughout the year, and he paid a full-time property manager to do the rest. Assume further that the rental produces a $100,000 loss. How does that change the analysis? In this case, A would still qualify as a real estate professional, by virtue of his 2,000 hours spent materially participating in his construction business. Simply qualifying as a real estate professional is not enough to convert A’s rental loss to nonpassive, however. In order for that to be accomplished, A must now establish that he materially participates in the rental activity, which he will fail to do by virtue of the fact that he spent only 50 hours on the activity, and other people spent more time than him on the activity. As a result, even though A is a real estate professional, his rental loss remains passive. As you can see, these rules are (fairly) straightforward when you have only one rental property. Where the IRS and courts have gone wrong, however, is in measuring whether a taxpayer with multiple rental activities qualifies as a real estate professional. Two Grouping Elections When a you have one activity under the meaning of Section 469—whether it be a rental property or a partnership or S corporation interest-- materially participating in the activity requires 500 hours of your time (assuming you don’t want to have to consider the hours of any other person participating in the activity), an achievable standard by even the laziest among us. But what if you have ten partnership interests? Or seven rental properties? Are you reasonably expected to spend 500 hours in each activity? The answer is no, and the regulations under Section 469 offer two alternatives for determining material participation when you have multiple activities. Under Reg. Section 1.469-4, you can elect to group activities together for purposes of measuring material participation; make the election, and you are permitted to aggregate the hours spent in the grouped activities. The regulations allow you to group activities however you see fit, provided that 1) the grouped activities represent an “appropriate economic unit,” and 2) you generally cannot group rental activities with nonrental activities. As a result, the -4 regulations are often referred to as the “slice and dice” elections, because you can carve up your activities into multiple groupings for purposes of measuring material participation. Of course, grouping together rental activities under the -4 regulations is largely a meaningless gesture, because unless you qualify as a real estate professional, it doesn’t matter whether you materially participate, because all rental activities are treated as passive under Section 469. To assist a real estate professional with multiple activities to overcome the treatment of rental activities as passive, the regulations offer another elective regime. Remember, qualifying as a real estate professional does not make your rental properties nonpassive; rather, it gives you the opportunity to establish that you materially participate in your rental activities, in which case they will become nonpassive. Reg. Section 1.469-9(g) provides that for purposes of establishing this material participation, a real estate professional may elect to treat all interests in rental activities as one activity. In contrast to the -4 election, the -9 election is an “all or nothing” election; you either group all of the rental activities, or you group none of them. If you make the election, you measure your material participation in your rental activities by summing the hours of time spent on all rental activities. Fail to make the election, and you must establish that you materially participate in each separate activity. So, if we layer the -9 regulations on top of the steps we established earlier for determining if you qualify as a real estate professional and can use rental losses without limitation, it would look like this. You must: 1. Participate in a real property trade or business as defined by the statute. 2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. 3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job. 4. The time spent participating in real property trades or businesses—but only those real property trades or business in which you materially participate—must exceed 750 hours. 5. You must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made. Tax Court Misinterpretation The IRS and courts have frequently made a mess of the steps described above. The problem has been the undue amount of importance placed on the “all or nothing” election of -9 to aggregate all rental activities of the taxpayer for purposes of measuring material participation. In several decisions, the -9 election has been elevated above its proper place in the real estate professional determination; the IRS has used the -9 election to determine if a taxpayer qualifies as a real estate professional, despite the fact that, as indicated above and quite plainly in the regulations, the -9 election applies only to a taxpayer who has already qualified as a real estate professional for the sole purpose of determining whether the taxpayer materially participates in his rental activities. In Jahina v. Commissioner, T.C. Summary Opinion 2002-150, a taxpayer was denied real estate professional status because she failed to make the election under -9 to aggregate all of her rental activities. As a result, the court concluded: As a consequence of the failure to elect, Mrs. Jahina must qualify as a real estate professional with respect to each property separately in order to avoid a determination that the rental activities were per se passive under Section 469. Thus, to hold in petitioners’ favor, the Court must find 1) That more than one-half of Mrs. Jahina’s personal services during the tax year were performed in each rental property activity and 2) that Mrs. Jahina performed more than 750 hours of services during the tax year on each of the claimed properties (emphasis added). The Tax Court employed a similar incorrect approach in Jafapour v. Commissioner, T.C. Memo 2012-165 and Hassanipour v. Commissioner, T.C. Memo 2013-88. If you’ve been following along, the problem with the Tax Court’s interpretation of the interplay between the two quantitative tests of Section 469(c)(7) and the “all or nothing” grouping election of Reg. Section 1.469-9 should quickly become evident. The Tax Court is using the -9 election to determine if a taxpayer qualifies as a real estate professional, despite the fact that the regulations make clear that the -9 election becomes relevant only after a taxpayer has satisfied those two tests, for the sole purpose of determining if the taxpayer materially participates in his rental activities. Therefore, the court is asking the taxpayer who fails to file a grouping election to satisfy two statistical impossibilities: 1) to spend more than half his time working on each rental activity, and 2) spend more than 750 hours on each rental activity (while technically not an impossibility, it becomes a realistic improbability as the number of rental activities increase.) This is not what the Code and regulations require, and placing this burden on a taxpayer can result in incorrect conclusions. To illustrate: A owns five commercial rental properties. He spends 600 hours on property A, 300 on property B, 300 on property C, 250 on property D, and 300 on property E. A performs no other services throughout the year. Assume that under Reg. Section 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in properties B, C, D, or E (i.e., he satisfied one of the other six tests for those four properties). Because he materially participates in each separate activity, A did not elect to group the activities together under Reg. Section 1.469-9. Assume each property produces a loss for the year. Using the Tax Court’s approach, because A failed to make the election to group the activities under -9, A must measure his qualification as a real estate professional on a property by property basis. Thus, because A did not spend more than 750 hours in any one property, he will fail to qualify as a real estate professional, and all of his losses will be treated as passive. Under the proper approach, however, we get a very different result. Let’s go back to our steps; A must: 1. Participate in a real property trade or business as defined by the statute. As a lessor of property, A meets this standard. 2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. A materially participates in each of his rental activities; 3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job. Because A materially participates in each separate rental activity, we can count the hours spent in each activity towards the total. He spent 1,750 hours on his real property trade or business (rental activities) and none on non-real property trades or businesses. As a result, this test is satisfied. 4. The time spent participating in real property trades or businesses—but only those real property trades or business in which you materially participate—must exceed 750 hours. Once again, because A materially participated in each rental activity, we can use all 1,750 hours for the purposes of this test. Thus, A has spent more than the requisite 750 hours. Because he has passed both tests, A qualifies as a real estate professional. Notice, we have not yet addressed the implications of making the “all or nothing” grouping election of -9. 5. You must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made. Now that A has established himself as a real estate professional—and only now—we look to whether an election to group his rental activities was made under -9. This is because the election is only relevant when a taxpayer who has qualified as a real estate professional under the two quantitative tests of Section 469(c)(7), as A has, must take the next step of establishing that he materially participates in his rental activities. Despite the fact that A has not made the election, because he materially participates in each separate activity, each activity is treated as nonpassive. By limiting the application of the -9 grouping election to after the real estate professional tests are satisfied, we get the correct result that A’s rental losses are nonpassive. The results would be equally as glaring if A were a real estate professional by virtue of a non-lessor activity. A work in construction for 2,000 hours per year. He also owns three rental properties. He spends 200 hours on property A, 200 on property B, and 200 hours on property C. Assume that under Reg. Section 1.469-5T, A materially participates in each property, even though he does not spend 500 hours in any one activity (i.e., he satisfied one of the other six tests for those four properties). Because he materially participates in each separate activity, A did not elect to group the activities together under Reg. Section 1.469-9. Assume each property produces a loss for the year. Under the court’s approach, because A did not make the grouping election under -9, A would have to satisfy the “more than half” and “750 hour” test for each property, which he clearly cannot do. Thus, he would fail to qualify as a real estate professional. Under the correct approach, however, A must: 1. Participate in a real property trade or business as defined by the statute. As a builder of real estate, A meets this standard. 2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T. A spends 2,000 hours in his construction business, and thus materially participates. 3. The time spent participating in real property trades or businesses—but only those real property trades or businesses in which the you materially participate—must exceed the time you spend in non-real property trades or businesses; i.e., your day job. Because A materially participates in his construction business and each of his three rental properties, we can count the hours spent in each activity towards the total. He spent 2,600 hours on his real property trade or business (construction and rental activities) and none on non-real property trades or businesses. As a result, this test is satisfied. 4. The time spent participating in real estate trades or businesses—but only those real estate trades or business in which you materially participate—must exceed 750 hours. Once again, because A materially participated in his construction activity and each rental activity, we can use all 2,600 hours for the purposes of this test. Thus, A has spent more than the requisite 750 hours. Because he has passed both tests, A qualifies as a real estate professional. Notice, we have not yet addressed the implications of making the “all or nothing” grouping election of -9. 5. You must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made. Despite the fact that A has not made the election to group his rental activities, because he materially participates in each separate activity, each activity is treated as nonpassive. The IRS Comes Around It appears that our long national nightmare of smart people misinterpreting the real estate professional rules has mercifully come to an end. In CCA 201427016, the IRS acknowledged the shortcomings of previous court decisions, and clarified that the “all or nothing” grouping election of Reg. Section 1.469-9 applies only after a taxpayer qualifies as a real estate professional. In the ruling, the facts were nearly identical to the example we just addressed. The taxpayer owned two rental properties and a development business. The taxpayer spent more than 750 hours—in total—on the three activities, and did not elect to group the two rental activities together. The ruling then succinctly addressed the issue that has been the subject of 4,000 words in this column: If a taxpayer fails to elect to group all rental activities together under Reg. Section 1.469-9, do the two quantitative tests of Section 469(c)(7) apply separately to each rental activity? The IRS concluded that they do not, once and for all clarifying that the determination of whether a taxpayer satisfies the real estate professional rules is unaffected by the -9 grouping election; rather, the grouping election is relevant only after the taxpayer qualifies as a real estate professional to determine if the taxpayer materially participates in his rental activities. Applying this rationale to the facts in in the ruling, the IRS concluded that: 1. The taxpayer was involved in a real property trade or business comprised of a development business and two rental activities; 2. The taxpayer materially participated in the real property trade or business by virtue of having spent more than 500 hours in the activity; 3. The taxpayer satisfied the “more than half” test; 4. The taxpayer satisfied the “more than 750 hours” test and thus qualified as a real estate professional. 5. At this point, the only thing standing between the taxpayer and nonpassive rental losses was the determination of whether he materially participates in the activities. Because no grouping election was made under -9, material participation had to be measured on a property by property basis. One property satisfied the material participation test; one did not. Summary If you’ve read this far, you've lost thirty minutes of your life that you’ll never get back, so hopefully you’ve learned something. Hopefully, you’ve learned that the “all or nothing” grouping election of Reg. Section 1.469-9 applies only after you determine if you are a real estate professional. So you’ve got that going for you. Which is nice. But more importantly, hopefully you’ve learned that tax law is hard. Partners get it wrong. The IRS gets it wrong. Tax Court judges get it wrong. So don’t beat yourself up. Keep reading, keep learning, and you’ll find yourself as well positioned as anyone to figure this stuff out. At least until it gets changed again.
LEER
