The passive loss rules enacted in 1986 aimed right at the real estate business. The rules, which disallow “passive” losses until they can be offset by “passive” income, generally treat rental real estate as “passive” no matter what.
There is a narrow exception for “materially-participating real estate professionals.” These taxpayers can determine whether their real estate rental is “non-passive” based on the usual rules for passive losses, which depend on how much time you spend on the activity. For example, your “materially participate” in an activity if you spend 500 or more hours on the activity in a year, or if you spend more than 500 hours on multiple activities that you spend 100-500 hours on each.
But first you have to be a “materially-participating real estate professional.” To qualify you have to meet two requirements under Sec. 469(c)(7):
- You have to work more than 750 hours in a “real property trade or business,” and
- your real property trade or business hours have to exceed your working time in non-qualifying businesses.
A Tax Court decision issued yesterday illustrated how hard it can be to clear this hurdle. A woman who worked as an office manager for a real estate broker (she wasn’t an owner) also owned and managed three rental properties with her husband. She claimed the rental property losses as non-passive.
The Tax Court pointed out an important limit on the real estate professional rule: it doesn’t count service “as an employee.” If you don’t own at least five percent of the business that gets you to your 750 hours, those hours don’t count. The court quoted IRS Publication 925:
Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer’s outstanding stock, outstanding voting stock, or capital or profits interest.
That meant the taxpayer, a Mrs. Bahas, had to meet the 750-hour test with just the rental properties. As the taxpayer stipulated that the time spent on the rental properties was less than 750 hours, she failed this test.
As an aside, the court made an assertion about the 750 test that strikes me as incorrect. The tax law allows qualifying real estate professionals to elect to “aggregate” their activities so they can combine their working hours for the material participation tests. The Court drew this conclusion:
Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.
Sec. 469(c)(7)(B) has the 750-hour requirement:
(B) Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if