Becoming a “Real Estate Professional”?

Introduction

Many people consider becoming “real estate professionals” to diversify income and to create tax losses from rental property to offset against earned income. I must preface with what I learned in my days in the tax law program—"do not let the ‘tax tail’ wag the dog.” You should arrange your business affairs in a manner that is tax efficient and in align with your business and investment goals and interests and not invest in something to create “tax losses” or do something just for “tax purposes.” With that said, tax planning is a popular topic and a necessity for certain business and investment owners. Learned Hand famously said the following in an opinion:

“Any one [sic] may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes.” Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934).

Arranging your financial affairs to pay the lower taxes should lead you to accumulate assets that lead to appreciation in value and/or payment of dividends, each of which are taxed at capital gains tax rates (0%, 15%, 20%, and 23.8%) instead of higher ordinary income tax rates on labor. At the same time, investors like deductions at ordinary rates. Thus, where do many gurus on social media, tax planners, and investors point people? Real estate. This article will cover one of the most common “tax planning” ideas people desire and misunderstand—the “real estate professional.” Most importantly, it discusses the real goal—becoming a real estate professional who materially participates in rental real estate.

Real Estate Investment Summary

Real estate investments can provide depreciation deductions over 27.5 years (residential) or 39 years (commercial) for structures, 15 years for improvements such as driveways, sidewalks, landscaping, and fences, and shorter periods (even in year one) for personal property acquired with real property (furniture, fixtures, appliances, etc.). While the rent is taxed at ordinary rates, depreciation can shield some or much of the income, particularly in the year of acquisition. Appreciation for the investor is taxed at capital gains tax rates (except for depreciation recapture), and like kind exchanges and qualified opportunity zone investments can defer the gain on real property by investing into new property.

“Having the Cake and Eating It To”: “Achieving the Losses” and Deducting Them

Depending on how you finance real estate’s acquisition (debt versus equity), it is possible to create “tax losses” while even having some cash flow positive income by having depreciation deductions that exceed the taxable positive cash flow (rent over expenses). While you can obtain positive cash flow, depreciation deductions and first-year expensing can create a “tax loss” on paper. Getting to deduct that “loss” against other income is sort of the “holy grail” of tax planning. Other than a limited $25,000 deduction for “active participation,” which is outside the scope of this article, Congress has passed limitations on the deductions of losses against other income.

Passive Activity Loss Rules

The primary limitation for this loss deduction is the passive activity loss rules. A passive activity loss is only allowed for deduction against passive activity income. Thus, without the exception below for real estate professional, a taxpayer with a passive activity loss cannot deduct the loss against other income. He would need other passive activities with positive income to deduct the loss from the passive activity.

A passive activity is an activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. See Section 469(c)(1) (the general rule). Another rule classifies any rental activity is a passive activity without regard to whether or not the taxpayer materially participates in it. See Section 469(c)(2). However, there is an exception for this special rental activity rule for certain taxpayers—where we get the term, “real estate professionals.” This term does not actually appear in the law, but it is a term given to persons who conduct themselves in a “real property trade or business,” under minimum participation requirements.

Misconception about Real Estate Professional

Here is where the misconception lies. You can meet the test for real estate professional (that is qualifying as being involved in a real property trade or business under minimum participation requirements), but you may not get to deduct the losses from rental activity against other income. The goal (the holy grail) is to become a real estate professional who materially participates in the rental activity.

Before discussing the requirements of a real estate professional, Section 469(c)(7) provides two results for taxpayers who meet this definition. First, the rental activity rule as a passive activity, found in (c)(2), does not apply to any rental real estate activity of such taxpayer for such taxable year. Second, the passive activity rules apply as if each interest in rental real estate was a separate activity, unless the taxpayer elects otherwise to aggregate the rentals. The first result means that the definition in 469(c)(1) still applies, thereby requiring material participation of the taxpayer in the rental activity, to avoid the passive loss rule restriction.

To become a so-called real estate professional, the taxpayer has to meet two tests: (1) 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 (2) 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.

There are many circular, overlapping requirements here! To summarize, a passive activity is a trade or business in which the taxpayer does not materially participate. A rental activity is a passive activity without regard to whether the taxpayer materially participates, except for a real estate professional who materially participates in real property trade or businesses for more than half of the service time of the year and for at least 750 hours.

Material Participation

First, before discussing material participation, I must define real property trade or business: it is “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” Thus, based on the first requirement, a taxpayer’s involvement in any and all of these trades or businesses should be examined to determine material participation. Rental is just one of them. Count the total hours spent in each real property trade or business in which you materially participate (the numerator). Second, count the total hours spent working for the entire year (the denominator). Divide. If the fraction is greater than 50%, then you meet the test. If you have a full-time job, not in the real estate industry, it will be hard to meet this rule. A real estate agent who is an independent contractor can count such time in the numerator and denominator.

What is material participation for applying the rule for the numerator? The code says that material participation is “involve[ment] in the operations of the activity on a basis which is regular, continuous, and substantial.” See 469(h)(1). That does not help much. The regulations (albeit still not finalized) give the following safe harbors for material participation:

(1) More than 500 hours of work in the activity for the year.

(2) The taxpayer’s participation is substantially all of the activity of all individuals in the activity for the year.

(3) At least 100 hours in the year in the activity and more than anyone else’s involvement.

(4) At least 100 hours in each activity and all such activities amount to more than 500 hours (thus, allowing combining multiple activities to meet the 500 hour rule).

(5) Material participation for any five taxable years during the last ten (whether or not consecutive).

(6) The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.

(7) A factual and circumstantial test, where the activity is regular, continuous, and substantial during the year.

If the taxpayer’s activity in the real property trade or business meets one of these seven tests, then he can include the time in the numerator for “material participation in the real property trade or business.” Once that test is passed, then it is onto test two. In the second test, the numerator must equal at least 750 hours. This rule requires at least part-time, minimal work and not just sporadic and occasional.

Passing the Test

If you are a real estate professional, then congratulations, you have accomplished the avoidance of the general rule that your real estate rental activity is a passive activity that prevents the deduction of losses against other income. The ultimate question, though, as discussed above, is whether you materially participate in the rental activity (or activities). For this ultimate test, thankfully, you can aggregate all rental activities (investments) together. Now, you must meet one of the material participation safe harbors above with respect to the rental activity to deduct the rental loss against other income, such as real estate commissions or other business income.

Who can fail the test? Let’s consider a real estate agent or broker who works throughout the year in real estate (2,000 hours or more) and who owns two rental homes. The agent can meet the material participation requirement of real estate brokerage, one of the real property trades or business. Thus, all this time is included in the numerator, test one of real estate professional. Let’s assume for the moment that she does not work more than 4,000 hours during the year. Thus, test one, the more than 50% test is met. She easily meets test two, the more than 750 hours for the numerator. The person is a real estate professional, but now we have to determine if she materially participated in rental activity.

Now assume the realtor spends approximately 5 hours per month total with the two rental homes, a total of 60 hours in the year (this time would not change the result of the real estate professional test). The 500 hour test is not met; the 100 hour test and more than anyone else is not met. Can she meet the rule that the taxpayer performed “substantially all the participation in such activity”? If she used a property manager, then the “substantially all” test is not met, because the property manager performed significant services. If she did not use a property manager, thereby taking care of all issues that arise with the properties (including tenant issues and calls), then she would qualify as a material participant, because “substantially all” the participation would be by her. Only then would she be considered as materially participating in the rental activity and avoiding the passive activity loss rule, thereby allowing her to deduct any rental loss against non-passive income. Without meeting this rule, she would be relegated to meeting the “facts and circumstances” test or a test involving prior years’ material participation.