The importance of determining whether a taxpayer involved in real estate activities is a real estate professional is twofold. First, it establishes whether the taxpayer can deduct losses from real estate activities against ordinary income. Second, it establishes whether income or gains from the real estate activities are subject to the net investment income tax.
Deductibility of rental real estate losses
Passive activity losses are only deductible against passive activity income. A passive activity is an activity involving a trade or business in which the taxpayer does not materially participate. Rental activities are generally considered passive activities regardless of whether the taxpayer materially participates (Sec. 469(c)(2)). Thus, the passive losses from such activities are usually only deductible against passive activity income.
If there is no passive income against which to deduct a passive loss, the loss is carried over to the following year. If a taxpayer qualifies as a real estate professional, however, the passive activity loss rules do not apply and losses from rental real estate activities are deductible against nonpassive income such as wages or Schedule C income (Secs. 469(a), (c)(2), and (c)(7)).
Qualifying as a real estate professional
A taxpayer qualifies as a real estate professional for any year the taxpayer meets both of the following requirements: (1) more than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated; and (2) the taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participated (Sec. 469(c)(7)(B)).
A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial. Generally, no interest in a limited partnership as a limited partner is treated as an interest with respect to which a taxpayer materially participates. Special limited rules exist for treating certain taxpayers as materially participating in a farming activity (Secs. 469(h)(1), (2), and (3)).
An individual is treated as materially participating in an activity if he or she meets one of the following seven tests:
The individual participates in the activity for more than 500 hours during the tax year;
The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
The individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
The activity is a personal service activity (i.e., it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting or in any other trade or business in which capital is not a material income-producing factor), and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year (Temp. Regs. Sec. 1.469-5T(a)).
An activity is a significant participation activity of an individual if and only if the activity (1) is a trade or business activity in which the individual significantly participates for the tax year, and (2) would be an activity in which the individual does not materially participate for the tax year if material participation for such year were determined without regard to item 4 above. Under this rule, an individual is treated as significantly participating in an activity for a tax year if and only if he or she participates in the activity for more than 100 hours during the year (Temp. Regs. Sec. 1.469-5T(c)).
A closely held C corporation or personal service corporation may be treated as materially participating in an activity if certain conditions are met (Sec. 469(h)(4)).
In determining whether 750 hours of services have been performed, personal services performed as an employee in a real property trade or business does not count unless the taxpayer is a 5% owner of the employer. If the taxpayer files a joint return, a spouse's personal services do not count toward determining whether the 750-hour requirement is met. However, a taxpayer can count a spouse’s participation in an activity in determining if the taxpayer materially participated (Sec. 469(h)(5)). Being “on call” does not count toward the 750-hour requirement (Moss, 135 T.C. 365 (2010)).
Each interest in a rental real estate activity is a separate activity, unless the taxpayer elects to treat all interests in rental real estate activities as one activity (Sec. 469(c)(7)(A)). The election, which is binding for all future years unless there is a material change in facts and circumstances, makes it easier to meet the material participation tests under the passive loss rules. The election is generally made by filing a written statement with an original tax return stating that the taxpayer is a real estate professional and electing to group his or her rentals as a single activity (Regs. Sec. 1.469-9(g)).
A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business (Sec. 469(c)(7)(C)).
Deductibility of losses on the disposition of real estate
The determination of whether a taxpayer is a real estate professional can affect the classification of a tax loss on the sale or disposition of real property. This is because a loss generated on property held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business is deductible as an ordinary loss rather than a capital loss (Connor, T.C. Memo. 2018-6).
Net investment income tax
In the case of a U.S. citizen or resident, a net investment income tax of 3.8% applies to the lesser of (1) the individual's net investment income for the tax year; or (2) the excess (if any) of the individual's modified adjusted gross income (MAGI) for the tax year, over the threshold amount (Sec. 1411(a)(1); Regs. Sec. 1.1411-2(a)). A taxpayer is not subject to the net investment income tax if the taxpayer's MAGI is under the threshold amount.
The threshold amount is: (1) in the case of a taxpayer making a joint return or a surviving spouse, $250,000; (2) in the case of a married taxpayer filing a separate return, $125,000; and (3) in the case of any other individual, $200,000 (Sec. 1411(b); Regs. Sec. 1.1411-2(d)(1)).
Net investment income for this purpose includes rental income and gain on the disposition of property less allocable deductions. Gross income is excluded from net investment income if it is derived in the ordinary course of a trade or business and is not income generated by a passive activity with respect to the taxpayer or income generated in the trade or business of a trader trading in financial instruments or commodities (Sec. 1411(c)(1); Regs. Sec. 1.1411-4(b); Regs. Sec. 1.1411-5(a)).
A special safe-harbor rule exempts gross rental income earned by certain real estate professionals from being included in investment income subject to the net investment income tax. That safe harbor provides that, in the case of a real estate professional who participates in a rental real estate activity for more than 500 hours during the year, or has participated in such real estate activities for more than 500 hours in any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year, (1) such gross rental income from that rental activity is deemed to be derived in the ordinary course of a trade or business; and (2) gain or loss resulting from the disposition of property used in such rental real estate activity is deemed to be derived from property used in the ordinary course of a trade or business (Regs. Sec. 1.1411-4(g)(7)).
For purposes of this safe harbor, a taxpayer is considered a real estate professional if he or she meets the requirements discussed above under “Qualifying as a Real Estate Professional.”
Even if the safe harbor provisions are not met, a taxpayer can still establish, through facts and circumstances, that rental income and gain or loss from the disposition of property, as applicable, is not included in net investment income under any other provision of Sec. 1411.