Deductibility of Rental Real Estate Expenses
Some of you may have been around long enough to remember the old days, prior to the enactment of the Tax Reform Act of 1986 (TRA ’86), when real estate tax shelters proliferated. Was real estate was such a lucrative investment that hoards of high earners couldn’t invest in limited partnerships fast enough? That wasn’t it. The highest federal income tax rate in 1985 was 50%. This was down from about 70% during most of the 1970s. These rates provided quite an incentive to find ways to minimize taxable income. One very popular method at the time was to invest in real estate that generated losses. In some ways, it was akin to buying a lower tax rate, provided you were a limited partner, with limited exposure.
Congress took note of the situation and felt that the use of tax shelters was undermining compliance in the tax system and diverting investment capital from productive activities to those principally or exclusively serving tax avoidance goals. They stated that “extensive shelter activity contributed to public concerns that the tax system was unfair, and to the belief that tax is paid only by the naïve and the unsophisticated.” So change was coming, indeed. Change that ultimately had a severe impact on the US real estate market in the mid-1980s.
In response to Congress’s concerns, Internal Revenue Code (IRC) §469 was enacted, otherwise known as the passive loss rules. Generally, a taxpayer may not use losses from a passive trade or business to offset income from other types of activities. While some amount of passive losses may be allowed in the year incurred, most of one’s passive losses are suspended and may be taken when there is a disposition of the property or activity. The rules can be complicated. We will visit some of the key elements and explore what the term “real estate professional” means to your clients.
What are Passive Activities?
There are two kinds of passive activities.
Trade or business activities in which the taxpayer does not materially participate during the year.
Rental activities, even if the taxpayer does materially participate in them, unless the taxpayer is a real estate professional.
We will focus on rental real estate activities.
Your client owns a house as an investment property. She advertises for renters, approves the potential renters, does all of the minor repairs herself and coordinates the larger repairs. The property has a net loss of $10,000 per year. No doubt, she actively participates relative to her rental real estate. Why does that matter? Even though this is a passive activity, there is an exception that may allow for the deduction of up to $25,000 of losses or credits ($12,500 for married individuals filing separate returns and living apart at all times during the year) against non-passive income, provided that she actively participates. Under a phase-out rule, the maximum special allowance of $25,000 is reduced by 50% of the amount of your client’s modified adjusted gross income that is more than $100,000 ($50,000 if she is married filing separately). If your client’s modified adjusted gross income is $150,000 or more ($75,000 or more if she is married filing separately), the special allowance generally cannot used.
“Adjusted gross income” is specifically defined for these purposes. IRC §469(i)(3)(F). These rules apply to operating losses, the rehabilitation credit (which has a higher phase-out limit), the commercial revitalization deduction and the low-income housing credit. There are ordering rules that apply to these deductions and credits. See IRC §469(i)(3)(E).
Using the example above, where your client has a $10,000 loss, if her modified adjusted gross income is, for example, $72,000, she may deduct the full $10,000 because she can make full use of the $25,000 special allowance. If, however, her income was $140,000, the special allowance that is available is reduced to $5,000. In the instance described above, your client could deduct $5,000 this year and must carry the remaining $5,000 forward.
Who can deduct all of the losses in the year incurred? The Real Estate Professional
There is a situation whereby your client’s rental real estate activity might not be deemed a passive activity at all. Should every client be gunning for that designation? As the requirements for the designation emerge, you can be the judge. To be a real estate professional under the law, your client must meet the following two tests:
More than half of the personal services your client performed in all trades or businesses during the tax year were performed in real property trades or businesses in which he materially participated.
Your client performed more than 750 hours of services during the tax year in real property trades or businesses in which he materially participated.
Let’s take this step by step. The first test, the “more than half” test, basically means that your client’s real estate activities have to be his primary occupation. If he has a full-time job and gets a W-2, there is a very low likelihood that he can pass this test. The second test requires that your client performed more than 750 hours of service in his real estate business during the taxable year. This is a bright line test – either he did, or he didn’t. How does your client prove the hours of participation in the business? The regulations indicate that “the extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” It is hard to imagine that a log would not be the best evidence.
This is something to think about in advance, because although “reasonable means” may be interpreted broadly, a post-event “ballpark guesstimate” will not suffice.
Both tests require that time spent or the hours counted is time during which your client materially participated in the business. What activities constitute “material participation” for these purposes? The material participation tests for these purposes are set forth in Temp. Reg. 1.469-5T (a). Your client must pass one or more of the following material participation tests:
1. More Than 500 Hours Test. Your client participates in the activity for more than 500 hours during the tax year.
2. Substantially All Participation Test. Your client’s participation in the activity for the year constitutes substantially all the participation by all individuals (including those who are not owners of interests in the activity such as lawn care workers, painters, repairmen, etc.).
3. More Than 100 Hours Test. Your client participates in the activity for more than 100 hours during the tax year, and no other individual participates more than the taxpayer. Again, hired workmen are included in the “no other individual participates more than the taxpayer” rule. The hours worked by contractors or subcontractors are counted as hours worked by others.
4. Significant Participation Activity (SPA) Test. The activity is a SPA (a term of art under Temp. Reg. 1.469-5T) in which the client participates for more than 100 hours during the year, and the client’s total participation in all SPAs during the year exceeds 500 hours.
5. Prior-year Material Participation Test. The client materially participated in the activity for any five of the ten years immediately preceding the tax year.
6. Personal Service Activity Test. The activity is a personal service activity, and the client materially participated in the activity for any three years before the year in question.
7. Facts and Circumstances Test. Based on relevant facts and circumstances, your client materially participated in the activity on a regular, continuous, and substantial basis during the tax year.
Under these material participation tests, married individuals can count participation by their spouses, whether or not a joint return is filed. Each interest in rental real estate is treated as a separate activity unless you elect to aggregate all rental real estate interests into a single activity (more on this later).
Real Estate Agents
It would seem logical that a real estate agent could use the hours spent working as an agent to determine if she is a real estate professional. But the statute defines “real property trade or business” as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” The IRS got overly focused on the term “brokerage trade or business,” and were not allowing agents to count their time for these tests. The test they were using was based on the definition of a real estate broker under state law. This result changed in 2009 when the Tax Court stated that whether a taxpayer is characterized as a broker or a salesperson for state purposes is irrelevant for federal income tax purposes. Rather, the test is whether she was engaged in “brokerage” within the meaning of Code Sec. 469. Consistent with her real estate salesman’s license and pursuant to her contract with the brokerage firm, the taxpayer was engaged in “brokerage”; i.e., she sold, exchanged, leased, or rented real property and solicited listings. Therefore, she was engaged in a “brokerage” trade or business within the meaning of Code Sec. 469(c)(7).
The Aggregation Election
As mentioned above, your client cannot group rental activities together for purposes of the material participation tests, unless an election to group them is made. If the election is not made, each property must meet the materiality and hours tests on its own. You might imagine that this would be nearly impossible for a client with multiple properties. The election is made by filing a statement with an original income tax return. There are specific information items that must be included and declarations that must be made on the statement. Until recently, if the election was not made with the return, a taxpayer could do little to apply the election later. That changed with Revenue Procedure 2011-34. If your client can meet the requirements set forth in the revenue procedure, it may be possible to make a late election.
So why wouldn’t everyone with multiple properties want to make the election when combining separate rental real estate activities may be the only way for an otherwise qualified real estate professional to satisfy the material participation requirement? Once the election is made, it is revocable only if there is a material change in the taxpayer’s circumstances. In some respects it is a double edged sword – the same election that allowed your client to be deemed a real estate professional by treating all real estate as one activity will continue to apply as the client disposes of the realty. This means that the sale of one rental property with substantial passive losses will not allow the client to use those losses in the year of the sale to the extent that they are not offset by current passive income. The losses would remain suspended until substantially all of the aggregated real estate is sold.
If your client is able to meet the strict real estate professional tests, he will be able to use the losses from his real estate business in the current year. If not, depending on his income, he may be able to deduct up to $25,000 if he meets the active participation test. When the client owns several pieces of rental real estate, consider making the election to aggregate the activities. Before recommending aggregation to your client, however, make sure that she understands both the upside and the downside of making the election.
STAFF OF J. COMM. ON TAX’N, 99TH CONG., GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986 (Comm. Print 1987), at page 210.
Section 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).
Moss v. Commissioner, 135 T.C. 365, 369 (2010) (and cases cited therein).
IRC Sec. 469(h)(5) and Temp. Reg. 1.469-5T(f)(3).
IRC Sec. 469(c)(7)(C).
Agarwal, TC Summary Opinion 2009-29.
I.R.C. § 469(c)(7)(A) & Treas. Reg. § 1.469-9(g)(3).
Rev. Proc. 2011-34, I.R.B. 2011-24, 875 (2011).