For Real Estate Professionals, IRS Concedes That 750-Hour Test Inapplicable On Per-Activity Basis Without Election

Overview

A taxpayer cannot fully deduct losses from a trade or business unless the taxpayer is a material participant in the business.  The tests for material participation are listed below.  If material participation is not present, the losses associated with the activity are passive.  In general, rental activities are passive, irrespective of how much time or effort the taxpayer puts into the activity.  Thus, if the rental activity produces losses, those losses only offset other passive income (if the taxpayer has any).  Excess losses that can’t be currently deducted get carried forward to years when they can be deducted.  There is also a “fallback” rule of active participation which allows the deduction of up to $25,000 of net rental real estate losses, but the $25,000 amount is phased-out by $1 for every $2 that the taxpayer’s adjusted gross income exceeds $100,000. 

However, “real estate professionals” get to fully deduct losses associated with real estate activities.  Under I.R.C. §469(c)(7), a real estate professional spends most of their time conducting real estate trades or businesses as compared to non-real estate activities (the “50 percent” test), and puts in over 750 hours in real estate activities (the “750-hour” test).  A real estate professional must also materially participate in real estate activities for the two tests to be satisfied – the activity has to be a real estate trade or business.  In the past, IRS has taken the litigating position that the 750-hour test has to be satisfied on a per activity basis absent an election to aggregate all of the taxpayer’s rental activities.  However, the Tax Court said that position was incorrect in a 2011 opinion and now the IRS has conceded the issue. 

The Material Participation Test

Under the passive loss rules, a real estate professional must materially participate in the real property trades or businesses in accordance with Treas. Reg. §1.469-5T.  There are seven tests, and the taxpayer only needs to satisfy any one of them.  Here are the tests:

• Participation for more than 500 hours during the year;
• Participation that constitutes substantially all of the participation by all individuals in the activity for the year;
• Participation for more than 100 hours during the year and no one else participates more;
• For multiple non-rental trade or business activities, participation (but not material participation) exceeds 100 hours in each activity and, in the aggregate, exceeds 500 hours;
• Material participation for any five years during the immediately preceding 10 years;
• Participation for any three years in the preceding the current year in a personal service activity (any trade or business in which capital is not a material income-producing factor); and
• Participation for more than 100 hours and, based on the facts and circumstances, participation is regular, continuous and substantial.

So, a taxpayer qualifies as a real estate professional if the 50 percent test and the 750-hour test are satisfied.  But, to be able to convert losses from rental activities to non-passive, the taxpayer has to establish that they materially participated.  Losses are not fully deductible losses if the taxpayer doesn’t materially participate in the activity. 

Multiple Activities

For a real estate professional, the material participation test is not a major problem when only one activity is involved.  But, multiple activities can be grouped for purposes of the material participation test.  Treas. Reg. §1.469-4 allows the grouping of activities that represent an “appropriate economic unit.”  Under that standard, non-rental activities cannot be grouped with rental activities.    But, a second grouping election contained in Treas. Reg. §1.469-9(g) allows a real estate professional to group all of their interests in rental activities as a single activity.  If this election is made, the real estate professional can add all of their time spent on all of the rental activities together for purposes of the 750-hour test.  But, if the election is not made, the material participation test must be satisfied with respect to each activity. 

Tax Court Confusion

In some early cases, the Tax Court held that a taxpayer was not deemed to be a real estate professional for failure to make the election under Treas. Reg. §1.469-9(g).  While the outcome of the case was correct, the court mistakenly said that the Treas. Reg. §1.469-9(g) election was relevant for determining whether the taxpayer was a real estate professional. Jafarpour v. Comr., T.C. Memo. 2012-165.  The Tax Court missed the mark again in Hassanipour v. Comr., T.C. Memo. 2013-88.  However, the Tax Court, in 2011, appeared to have gotten the election issue correct.  Miller v. Comr., T.C. Memo. 2011-219.  In that case, the taxpayer didn’t make the Treas. Reg. §1.469-9(g) election, but the court did not require the taxpayer to meet the 750-test with respect to each of the taxpayer’s activities. 

IRS Clarification and Concession

Now, in Chief Counsel Advice 201427016 (Apr. 28, 2014), the IRS stated that the Treas. Reg. §1.469-9(g) aggregation election “is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.”  Thus, the IRS has now conceded that whether a taxpayer is a real estate professional for purposes of the passive loss rules is not affected by an election under Treas. Reg. §1.469-9(g).  In other words, the election under Treas. Reg. 1.469-9(g) has no bearing on the issue of whether a taxpayer qualifies as a real estate professional – puts in more than 750 hours in real estate activities and satisfies the 50 percent test.  But, once a taxpayer qualifies as a real estate professional, the requirements for material participation are applied as to each separate activity absent an aggregation election.  But, the key point is that the 750-hour test is not applied as to each separate activity.  To have the IRS actually follow the statute is a big help to many taxpayers.