One of the hidden advantages of being in the real-estate business is the ability it provides to deduct otherwise “passive” rental losses. If you are a “real estate professional” under Code Sec. 469(c)(7), rental real-estate losses aren’t “per-se” passive, like they are for other taxpayers; instead, you determine whether your real estate losses are “passive” using the same “material participation” tests that apply to all other business activities. A “real estate professional” has to spend 750 hours or more a year in a “real property trade or business” and cannot work more hours in non-real estate businesses than in real estate.
Sudha Agarwal was a full-time real-estate agent at a Century 21 brokerage in California. She also owned two rental properties with her husband. Together Mr. and Mrs. Agarwal performed all of the work on the properties, meeting one of the tax law’s tests for material participation. She therefore claimed the losses as non-passive, and deductible, based on her status as a “real estate professional.”
The IRS disagreed, making the arguing that Mrs. Agarwal wasn’t a “real estate professional” under the tax law. The tax law defines “real property trade or business” (my emphasis):
any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
The IRS made the novel argument that a real estate “agent” isn’t in the “brokerage” business. The Tax Court explored the meaning of “brokerage” in Sec. 469(c)(7) and concluded that it meant what every normal person would conclude: that real estate agents are in the “brokerage” business.
Cite: Agarwal, T.C. Summary Opinion 2009-29.
Read more for an overview of the tax law rules for “material participation.”
MATERIAL PARTICIPATION BASICS
The regulations say you achieve “material participation” in non-real estate activities for a tax year if:
-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other “100 hour” activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).
There is also a “facts and circumstances” test, but don’t count on it.
A special rule apples to real estate. If you are not a “real estate professional,” losses are normally passive no matter what, unless you provide “extraordinary” personal services.
If you are a “real estate” professional,” you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours – not less than 750 hours annually – in “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade.”