I am glad to see that the IRS has reversed course on an issue concerning real estate professionals.
You may remember that “passive losses” entered the tax Code in 1986 as retaliation against tax shelters. The IRS had previously battled tax shelters using challenges such as “at-risk,” but 1986 brought a new and updated weapon to the IRS armory.
The idea is simple: separate business activities into two buckets: one bucket for material participation and a second for passive. The classic material participation is an activity where one works more than 500 hours. Activities in the material participation bucket can offset each other; that is, losses can offset income.
Move on to the second bucket. Losses can offset income – but not beyond zero. The best one can do (with exceptions, of course) is get to zero. One cannot create a net loss to offset against net income from bucket one.
Consider that tax shelters were placed into bucket two and you understand how Congress changed the tax Code to pull the rug out from under the classic tax shelter.
It was quickly realized that the basic passive activity rules were unfair to people who made their living in real estate. For example, take a real estate developer who keeps a few self-constructed office condominiums as rentals. If one went granular separating the activities, then the real estate development would be a material participation activity but the condominium rentals would be a passive activity. This result does not make sense, as all the income in our example originated from the same “activity.”
So Congress came in with Section 469(c)(7):
469(c)(7) SPECIAL RULES FOR TAXPAYERS IN REAL PROPERTY BUSINESS.—
469(c)(7)(A) IN GENERAL.— If this paragraph applies to any taxpayer for a taxable year—
469(c)(7)(A)(i) paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and
469(c)(7)(A)(ii) this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.
Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.
469(c)(7)(B) TAXPAYERS TO WHOM PARAGRAPH APPLIES.— This paragraph shall apply to a taxpayer for a taxable year if—
469(c)(7)(B)(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
469(c)(7)(B)(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Here for example is the Court in Bahas:
Mrs. Bahas misconstrues section 469. 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 real estate as if it were a separate activity. 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.”
How in the world did we get from 500 hours to 750 hours for each of Mrs. Bahas’ activities? This is not what Section 469(c)(7) appears to say. There was a torrent of professional and academic criticism on Bahas and related decisions, but in the interim practitioners (me included) elected to aggregate all the real estate activities into one activity. Why? To make sure that one got to the 750 hours, that is why.
Academicians could argue the sequence of phrases and the intent of the law. Practitioners had to prepare annual tax returns, protect their clients and wait their time.
And now it is time.
The IRS released ILM 201427016 to discuss how the “750-hour test” works when one has multiple real estate activities. It includes the following obscuration:
"However, some court opinions, while reaching the correct result, contain language which may be read to suggest that the election under Treas. Reg. 1.469-9(g) affects the determination of whether a taxpayer is a qualified taxpayer.”
The IRS finally acknowledged that the 750-hour rule is not a substitute or override for the generic 500-hours-to-materially-participate rule. A real estate taxpayer goes activity-by-activity to determine if he/she is materially participating in each activity. If it is advantageous, the taxpayer can also make an election to aggregate all real estate activities before determining material participation status.
Then, once all that is done, the IRS will look at whether the taxpayer meets the more-than-half and more-than-750-hours tests to determine whether the taxpayer is a real estate pro.
There are two separate tests. One is to determine material participation and a second to determine real estate pro status.
A bit late for Mrs. Bahas, though.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.