The IRS defines rental activities as inherently passive, which means that any losses from rentals can only be offset by other passive income. However, if your clients engage in real estate as a trade or business, they can take advantage of an exception to this rule.
By qualifying as a real estate professional, passive losses from real estate become ordinary losses, which can offset ordinary income. Be aware that the rules to qualify as a real estate professional are complex – and this article is only an overview. This article in The Tax Advisor has a detailed procedure to make sure your clients pass IRS muster.
To qualify as a real estate professional, your clients must pass both of the following tests:
- More than half of the personal services provided during the year must be in real property trades or businesses.
- They must perform at least 750 hours of personal services in these trades or businesses.
The first test disqualifies most people who also have full-time jobs in other occupations, but if your clients keep meticulous records of their time and are willing to work long hours, it can be done.
Qualifying as a real estate professional is only the first hurdle to cross before rental activities can be treated as non-passive. Your clients must also establish material participation in their rental activities. For material participation, IRS temporary regulation 1.469-5T(a) provides seven tests. Your clients need to pass just one of these for each rental activity:
- They participate in the activity for more than 500 hours during the year.
- They do substantially all of the work in the activity during the year. This includes any work done by any other individuals, including non-owners.
- They participate in the activity for more than 100 hours during the year and no other person (including non-owners) participates more than they do.
- The activity is a significant participation activity, and the sum of all the time they spend on their significant participation activities exceeds 500 hours. A significant participation activity is a trade or business activity in which they spend at least 100 hours during the year.
- They materially participated in the activity during five of the previous 10 years.
- The activity is a personal service activity, and they materially participated in it during any three prior years.
- Based on all facts and circumstances, they participated in the activity on a regular, continuous and substantial basis during the year. This test only applies if they work at least 100 hours in the activity, no one else works more than they do and no one else receives compensation for managing the activity.
Clients can also elect to group their rental activities to satisfy these tests. This is done by attaching a statement to their return, stating that they are electing to group their rental activities. This is an all-or-none election, and it remains in place until they revoke it, which can only be done if their current situation has changed since the election was made.
A downside to grouping rental activities is that any suspended losses will remain suspended until they dispose of all of their rental properties.
Keeping good records is generally a requirement to pass IRS muster. However, a recent case before the U.S. Tax Court (Hailstock v. Comm., TCM 2016-146) demonstrated that “detailed and credible testimony” can suffice. Between 2005 and 2009, Beth Hailstock owned some 30 properties that she variously rented, held as investment property or sold. Her records of income and expenses were scattered and incomplete. She had no documentation of the time she spent on her activities.
Yet, because she had no outside employment during those years, and provided credible testimony regarding her daily activities, the judge agreed with her status as a real estate professional and acknowledged she passed the tests for material participation in all of her rental properties. All of her rental losses were deductible.
However, as the judge cautioned Ms. Hailstock, and as your clients should be aware, keeping detailed records of activities in the future is highly recommended.
Editor’s note: This article originally appeared on the Firm of the Future blog.