Are you a materially-participating real estate professional?
INSIGHT ARTICLE |
The real estate professional rules under section 469 were enacted as part of the Tax Reform Act of 1986. Although the rules have been in existence for quite some time, the enactment of the Affordable Care Act and with it, the 3.8 percent tax on net investment income under section 1411, has renewed interest and discussion on the subject in the real estate industry. Perhaps not so coincidentally, the industry has also seen increased audit activity in this area as the Internal Revenue Service (IRS) challenges certain taxpayers claiming the real estate professional designation. Given the potentially significant implications the real estate professional designation can have on the ultimate tax treatment of an individual’s rental income, taxpayers should be proactive in discussing this issue with their tax advisors.
The purpose and scope of this article is to provide a summary of the real estate professional rules under section 469 and to touch on some of the related nuances.
Summary of the real estate professional rules under section 469
Qualifying as a real estate professional can have significant tax implications with respect to both the passive loss rules and the net investment income tax (NIIT). Satisfying the real estate professional requirements enables a taxpayer to avoid the per se passive rule under section 469(c)(2) that ordinarily applies to a subset of the qualifying real estate professional’s activities – rental activities. Instead, a qualifying real estate professional’s rental activities are analyzed with respect to the general passive loss rules. For real estate professionals, this would sometimes allow them to utilize current year operating losses from the rental activities against other types of income rather than only being able to utilize them against passive income. In addition, rental income recognized by a qualifying real estate professional who materially participates in the rental activities is not subject to the 3.8 percent net investment income tax.
But taxpayers should not assume that simply working in real estate is sufficient to qualify as a real estate professional under the applicable rules. In fact, a taxpayer must pass two quantitative tests under section 469(c)(7)(B) to be considered a qualified real estate professional:
- The taxpayer must spend more than 50 percent of his or her personal service time in real property trade or business activities in which the taxpayer materially participates.
- The taxpayer must spend more than 750 hours in real property trade or business activities in which the taxpayer materially participates.
In the case of a joint return, these tests need only be satisfied by one of the spouses. But note that this is an annual test. Thus, qualification in a prior year does not guarantee the same treatment in a subsequent year. Similarly, failing to meet the test in a given year does not preclude the individual from satisfying the requirements the following year.
50 percent personal service time and material participation
The first test essentially requires that the individual devote over 50 percent of his or her working hours to real estate activities in which he or she materially participates. As such, a person with a full-time job in an unrelated field will almost certainly struggle to satisfy this first prong of the requirement. Note that in order for a taxpayer’s time to count toward the 50 percent threshold, the taxpayer must first materially participate in the activity. Thus, it is important to first assess whether a taxpayer materially participates in a real property trade or business, and then compare the hours spent in all such activities to the total personal service time worked in all activities to see whether the first test has been satisfied.
Under section 469(c)(7)(C), the term “real property trade or business activities” includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Another key term is material participation as defined under Reg. section 1.469-5T. We will not review the rules for material participation but it is worth noting that the regulations outline seven ways in which one can establish material participation in an activity. The taxpayer must meet one of these seven tests in order to fulfill the material participation requirement.
Spend > 750 hours
The second test that must be met is the 750 hour test. The taxpayer carries the burden of proof to substantiate that he or she spends at least 750 hours per year performing services for these activities. It is imperative to keep accurate and detailed records that track specific tasks, meetings, responsibilities, locations, etc. This is very important as the IRS has recently won a stream of court cases where taxpayers failed to provide adequate documentation to support their time spent in qualifying real estate activities.
A taxpayer who is an employee of a real estate company and who, on a day to day basis, is engaged in real property activities may believe that achieving the 750 hour requirement will not pose a problem. After all, this individual may devote well over 2,000 hours to his real estate job each year. However, as prescribed by section 469(c)(7)(D)(ii), time spent as an employee in real property activities counts only if the taxpayer owns more than 5 percent of the entity. The 5 percent ownership test generally includes direct ownership, but it can also include indirect ownership. If the employer is a corporation, the constructive ownership rules under section 318 apply, meaning ownership would include a taxpayer’s indirect interest(s) in the employer held through a partnership interest or a taxpayer’s interest as a beneficiary of a trust, as well as interests owned by family members. If the company is not a corporation, the 5 percent ownership is determined by the employee’s capital or profits interest in the employer.
Rental activity aggregation election
A taxpayer who satisfies these two tests, and therefore is a qualified real estate professional, is only part way there. Being a qualified real estate professional simply means that the taxpayer is not subject to the per se passive rule with respect to his or her rental real estate activities. But the taxpayer must still materially participate in his or her rental activities in order to avoid passive treatment with respect to those activities.
This determination is normally made on a property-by-property basis. In situations where the taxpayer owns many rental properties, it would ordinarily be difficult to meet the material participation thresholds for any one activity by itself. Fortunately, there is a potential solution to this problem. If a qualifying real estate professional holds a direct or indirect interest in multiple rental properties, he or she should consider making an election under section 469(c)(7)(A) to aggregate the hours spent in all of rental activities in order to meet the material participation thresholds. It is important to note that hours devoted to a rental property held indirectly through a real estate investment trust (REIT) do not necessarily count for purposes of the hour tests. In other words, a taxpayer who invests in rental assets through both REIT and non-REIT structures may need to be cognizant of the hours spent on the non-REIT assets.
The real estate professional rules are not new, but recent legislation, court decisions, and increased IRS audit activity has renewed discussion in this area. Please discuss with your tax advisor the applicability of these specific rules to your situation to determine if you can qualify for and benefit from this designation.