Real estate seems like a fun, easy form of passive investment that can be used to pad pockets or build a portfolio. In many ways, this is true – real estate offers plenty of potential for those with economic smarts and a moderate sense of risk. However, when it comes to taxes, the water grows far murkier.
While most business opportunities allow the ability to use losses to offset gains, real estate brings additional issues to light – namely, the ability to offset active income with passive losses. Due to this benefit, it’s not uncommon for hobby investors to attempt to categorize themselves as real estate professionals for tax purposes. As such, it’s no surprise that this issue appears in Tax Court with alarming regularity, or that tax professionals frequently find themselves working to prove that, yes, their clients are indeed qualified to call themselves pros in the real estate space. For those who dabble in real estate, understanding the relevant rules and regulations is critically important.
Passive Activity Loss Rules and the Exceptions for Real Estate Professionals
Per Sections 162 and 212, taxpayers are generally permitted to take deductions for all necessary expenses included in the course of a trade or business. However, Section 469 imposes limitations here when activities are deemed to be passive, or any business in which the taxpayer does not participate materially. Rental real estate is, by default, incorporated into the passive category, disallowing a large portion of losses that could otherwise be claimed.
However, this rule doesn’t apply for real estate professionals; for those who treat real estate as a career, passive income can instead be classified as a per se activity, allowing for the deduction of losses above the passive income loss limitations. Further, those actively involved in real estate can deduct up to $25,000 in real estate losses as long as AGI is $100,000 or less. With an AGI between $100,000 to $150,000, this deduction amount is reduced by 50% of the amount over $100,000.
The result? Treatment as a real estate professional is a highly coveted position.
Exceptions for Real Estate Professionals
Real estate rentals are considered, by default, a passive activity, but the cracks in this logic start to form in Section 469(c)(7), which indicates that activities by a real estate professional are not considered passive as long as the material participation requirements in Section 469(c)(1) are met. But who is a real estate professional? Luckily, the code answers this, too, requiring that the following criteria be met:
- One half or more of personal service performed in a trade or business throughout the year must be involved in real property in which the taxpayer materially participates
- Over 750 hours of material participation in the real estate trade or business
Luckily, Section 469(c)(7) also details what is included as a real property trade or business: “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” For a joint return, these requirements are considered satisfied if either spouse separately meets criteria.
Note that material participation is an indisputable part of the qualification as a real estate professional. This is clarified to refer to any basis that is “regular, continuous, and substantial.” This, of course, opens the door for plenty of arguing that work that is not truly substantial meets these arbitrary cutoffs, so the Temporary Treasury Regulations established seven benchmarks, at least one of which must be met for this presumption to be valid. These are:
- More than 500 hours of participation throughout the year
- Participation by the individual constitutes the majority of the participation in all such activity of all involved individuals
- More than 100 hours of participation throughout the year, and no less participation than any other member of the venture
- Significant participation of over 500 hours in the taxable year
- Material participation for any five of the last 10 taxable years
- Classification as a personal service activity in which the individuals participated for at least three years preceding the current taxable year
- Participation on a continuous, regular, and substantial basis according to all facts and circumstances
While the courts have shown a preference for easily quantifiable records, like timesheets, this is not the only evidence that can be used to indicate substantial participation; any reasonable means can be used. Further, if a married couple participates in a venture jointly, both spouses’ time involvements are treated as one, even if they file separately.
For taxpayers with multiple properties, things fragment even further. Each property is considered a different activity for tax purposes, making it harder to demonstrate material participation – unless, of course, a taxpayer has a case as a real estate professional.
Exceptions for Active Participation
In general, real estate renting is considered a passive activity, and by and large for good reason – most property owners don’t play a substantial role in managing things, instead handling calls on an as-needed basis or hiring a third party to work as a go-between. However, there’s a second exemption buried in 469(i) for those who actively participate in the real estate industry. For active participants, it is possible to deduct up to $25,000 in losses so long as AGI is under $100,000. This amount phases out for an AGI between $100,000 and $150,000.
It is important here to distinguish between material participation and active participation. Despite the similar-sounding names, these terms actually have two different distinct meanings. As compared to material participation, which is defined above, active participation is a little looser, requiring only an ability to make management decisions or assigning property services to others. For middle-class families with real estate holdings, the active participation loophole can be a significant benefit.
Net Investment Income Tax
The Health Care and Reconciliation Act of 2010 may not seem particularly tax-related, but the passage of this key bill was central to what is now known as Obamacare – and how Obamacare is funded. As a part of this, a tax of 3.8% was added to unearned income, or any passive income sources, like interest, dividends, and, of course, real estate rental income, for taxpayers with a MAGI over $200,000 for single filers or $250,000 for married.
For those with substantial rental income, this can be a blow, but real estate professionals are off the hook as real estate isn’t considered passive for those who do more than dabble. Have more than 500 hours to invest in real estate this year? You’re good to go.
Likely Litigations: Failure of Substantiation as to Real Estate Professional or Active Participant
As with most tax issues, the IRS isn’t just going to accept the fact that a taxpayer is a professional in the real estate realm, but many prospective investors aren’t necessarily aware of this until it’s too late. As such, issues of substantiation frequently come under fire in the courtroom, with taxpayers trying to prove that 469(c)(7)(B)(i) and (ii) are met. In many cases, taxpayers assert they meet the requirements for either an active participant or a real estate professional but are unable to provide tangible support for such claims. Take, for example, Coastal Heart Medical Group, Inc. v. Commissioner: in this case, the taxpayers claimed that they spent 14 to 16 hours a day, seven days a week, negotiating the price of hospital properties. However, as there was absolutely no evidence whatsoever that this was the case, the judge was not inclined to listen to hearsay and play along. Their claim was dismissed as a “ballpark guesstimate,” and the taxpayers were encouraged to keep better records in the future. While written proof isn’t required, it is highly suggested, and some judges may expect it unilaterally, requirements be damned.
In Jafarpour v. Commissioner, a logbook was presented as support of the taxpayer’s professional involvement in real estate, but it wasn’t accepted. Rather than keeping neat, meticulous records, the taxpayer’s notes were largely illegible and illogical, and there were discrepancies between the taxpayer’s cell phone records and the times stated to be involved in real estate. Further, many claims were incongruous with reality, like devoting days to scoping out neighborhoods and taking an hour to read a one-line email. As such, the Court determined the entire logbook was “tainted with incredibility.” In another case, Escalante v. Commissioner, the Tax Court determined that despite adequate recordkeeping, there was not substantial evidence to indicate that the taxpayer spent more time on real estate than his primary job, teaching school, and thus was unable to determine material participation.
In the case of Moss v. Commissioner, taxpayers tried a different tactic to get out of passive income and loss restrictions, claiming that the time spent “on call” for their rental properties, or standing by in case tenants had issues, should count toward active participation. The Tax Court disagreed, stating that just because the taxpayer was available to perform services does not mean any contribution was made toward property management.
There is recourse available should records be destroyed. If a taxpayer kept records that are inaccessible for some reason, taxpayers are permitted to recreate records as best as possible using other forms of evidence, like phone records, GPS data, and email records.
Through these examples, taxpayers considering making a case as to active real estate investment should keep the following in mind:
- While records are not required, they are highly suggested
- Records should be accurate and realistic
- On-call hours are not acceptable
- Destroyed records can be recreated if needed
- Failure to document more than the bare minimum hours required for a taxpayer’s non-real estate job can make it impossible to determine the true time breakdown and draw the taxpayer’s real estate activities into question.
Proving Active Participation
If taxpayers made a case as to status as a real estate professional and were found to be ineligible according to the two-pronged test in Section 469(c)(7)(A), active participation may still be an alternative. As this threshold is far easier to demonstrate, taxpayers may be able to argue the management decisions and services made in the course of business. However, for many taxpayers, the $25,000 deduction pathway is still unavailable due to the modest $100,000 AGI cutoff.
Likely Litigations: Failure to Make the Aggregation Election
For those with multiple rental properties, meeting the material participation requirement can be even more challenging. After all, there are only so many hours in a year that can be invested in real estate endeavors. For this reason, many individuals with significant real estate holdings often attempt to treat all rental activity as a single activity rather than numerous separate activities. This election isn’t assumed – a taxpayer must file a statement explicitly stating that he meets the requirements to be a real estate professional. After filing, this election is binding for the tax year in which it is made and all future years in which the taxpayer is a qualifying real estate professional. The election can be revoked only in a year in which there is a material change in circumstances that makes the claim no longer true. This requires a separate statement stating the changes to be filed with the original return in the year of revocation.
Failing to Make an Election
Don’t assume that just because you’re a real estate professional (or representing one) that the IRS will be lenient about this kind of election. This was proven to be true in Kosonen v. Commissioner: even though the IRS concluded that the taxpayer qualified as a real estate professional, it was determined that the election was not properly made and, in addition, the taxpayer failed to meet the requirements under Section 469(c)(7)(A)(i) and (ii) for each rental activity. The Court did not agree that the taxpayer treated his losses as active and disregarded the claimed intent to make the election; in the eyes of the law, planning to make an election isn’t the same thing as actually making an election.
Filing a Late Election
Meant to file an election but forgot? Never fear – there may still be time. The IRS does permit late elections to be made by making an election with an amended return for the most recent tax year. This amendment must also include:
- An explanation for why the election wasn’t made on time
- Statement of the tax year the election pertains to
- Evidence that the taxpayer a) only failed to make an election due to time, b) filed returns on time without the election, c) filed all other returns that would have been affected by the election on time, and d) had reasonable cause for failing to file an election on time
- A declaration that the information provided was made under penalty of perjury
- A statement at the top that reads “FILED PURSUANT TO REV. PROC. 2011-34”
Despite the fact that this option is permitted, thus far, the Court has yet to accept a delayed election after a notice of deficiency has been issued.
Disadvantages of the Aggregate Election
An aggregate election seems like an advantage – the ability to treat all property interests as a single activity can be a benefit in proving material participation – but it’s not all roses. There are some downsides to an aggregate election, namely the complete disposition rule under Section 469(g). When properties are not aggregated, the rules stipulate that passive losses come to a close when an activity is disposed of, but when activities are aggregated, this means that the passive losses allocable to real estate interests can’t be freed up, so to speak, until all properties are fully eliminated. As such, it may be advantageous to time aggregate elections around future planned sales.
Qualification as a Real Estate Professional
Qualifying as a real estate professional may seem like a fun, easy alternative to garner better tax treatment, but the reality usually looks a little something like an actual career in real estate – and that’s not something appealing to everyone. In considering what constitutes a real estate professional, Courts often consider the duties being performed. While not an exhaustive list, the following tasks are the kinds of things the Courts expect to see when reviewing a case:
- Evaluating and performing background checks on prospective tenants
- Preparing leases
- Answering tenant questions
- Cleaning and preparing rental units in between tenants
- Working to secure new tenants
- Purchasing supplies to be used in rental units
- Repairs of rental units for existing tenants
- Maintenance and repairs on common areas
- Lawn care and maintenance
- Supervising contractors and agents
- Bookkeeping, accounting, and banking
- Paying expenses related to the care of the property
- Coordinating with accountants and attorneys as needed
- Collecting rent
Recent Case Law
With adequate evidence, numerous taxpayers have successfully battled through real estate cases in Court. In Brown v. Commissioner, the Tax Court ruled in favor of the taxpayer, declaring that rental activity did not result in passive losses. In this case, the taxpayer owned a multi-family dwelling and lived on the first floor. In 2010, he worked 1,284 hours – 1,008 of which were allowed – on the property, and 752 allowed in 2011. The taxpayer’s detailed logs were key in this case, and it’s what the taxpayer’s argument hinged on. The story in Leyh v. Commissioner was similar, too; the taxpayer’s logs were adequate. They originally weren’t – travel time was neglected – but with amendments to account for time in transit, the Court saw merit in the taxpayer’s argument. The IRS attempted to claim that the original log should stand, but the court rejected this, indicating that correctness matters just as much as contemporaneousness.
AirBnB and the Case of the Temporary Landlord
Just 10 years old, AirBnB has yet to disturb the landscape of real estate taxes, but this is surely only a matter of time. A service that allows individuals to rent out space in their home on an extremely temporary basis, AirBnB has revolutionized travel – and rental income. For those who want to make a living on AirBnB rental income, however, the law may not be a benefit. Section 280A(d)(1), for example, treats property that has been used as personal space for 14 days or 10% of the time a property is rented at a fair market price as residential property. This means that even passive losses may be disallowed. Before jumping into AirBnB, it’s prudent to review the laws inside and out to be sure everything is by the book.
To Rent, or Not to Rent
Real estate is a complex industry, and the convoluted tax rules only add to the challenges. For those considering acting as a landlord or diving into the deep end of property investment, a thorough acquaintance with tax law is suggested. After all, one wrong move can be enough to cost you potentially thousands in savings.