Real estate professional status can provide relief from the passive activity loss limitation rules1 and the 3.8% net income investment tax (“NIIT”),2 resulting in significant tax savings.
Rental activities are, per se, passive.3 Passive activity loss (“PAL”) rules limit the ability to offset net losses from passive activities (like rental income) against other nonpassive sources of income (like wages). PALs may be deducted only to the extent of a taxpayer's passive activity income. The remainder is carried forward to be used when the passive activities generate a gain or upon disposal of the property or activity.4 However, a real estate professional who materially participates in a real property trade or business is not subject to the PAL limitation rules and may use rental losses to offset other sources of nonpassive ordinary income.
Real Estate Professional Test
To qualify as a real estate professional, a taxpayer must satisfy the following tests:5
- Perform more than 50% of services in real property trades or businesses (“50% test”), and
- Perform more than 750 hours of service in real property trades or businesses (“750 hours test”), and
- Materially participate in each rental activity (“material participation test”).
A real property trade or business is broadly defined to include real property development, re-development, construction, re-construction, acquisition, rental, operation, management, leasing or brokerage trade or business.6
The IRS requires detailed records to support the hours worked in real estate compared to those worked in other business. 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.7 Post-event "ballpark guesstimates" or unverified, undocumented testimony may be insufficient.8
The 50% test and 750 hours tests must be met by one spouse alone. However, all real property trade or business activity is included under the 750 hours test, regardless of whether an election has been made to aggregate the properties into one real property trade or business9.
Material participation is determined separately for each rental property unless the taxpayer elects to treat all interests as a single rental real estate activity. As a general rule, the election is binding until revoked and covers future purchases10.
To be considered a “material participant,” a taxpayer must satisfy at least one of the following:11
- Taxpayer works more than 500 hours in the activity. Unlike the 50% and 750 hours tests, participation of both spouses is counted for material participation.12 Participation by children or employees is not counted;
- Taxpayer does substantially all of the work in the activity;
- Taxpayer works more than 100 hours in the activity and no one else works more than the taxpayer (including non-owners or employees);
- The activity is a significant participation activity (SPA), and the taxpayer’s total time in all SPAs exceeds 500 hours. Rental or leasing activity is not considered an SPA;
- Taxpayer materially participates in the activity in any five of the prior ten years;
- Taxpayer materially participates in a personal service activity13 for any three prior years; or
- Based on all facts and circ*mstances, taxpayer participates in the activity on a regular, continuous and substantial basis during such year.14
Net Investment Income Tax and Real Estate Professional Status
Another benefit of qualifying as a real estate professional is relief from the 3.8% tax on passive net investment income imposed under NIIT if:
- The taxpayer meets the definition of real estate professional test as described above, and
- rental income is derived in the ordinary course of a trade or business and the rental activity is not a passive activity under existing law.
If the real estate professional participates more than 500 hours in the current taxable year (or more than 500 hours per year in any five of the previous ten years, whether or not consecutive), a safe harbor rule deems rental income associated with the activity to be derived in the ordinary course of business.15
Recent Cases
IRS scrutiny over who qualifies as a real estate professional is a constant. Recent court decisions serve as a strong reminder of the substantiation required to qualify as a real estate professional.
In Sezonov v. Commissioner, T.C. Memo 2022-40, husband and wife HVAC business owners who owned rental properties and claimed they qualified as real estate professionals were denied passive activity loss deductions under IRC Sec. 469(c)(7). Mrs. Sezonov was responsible for most of the day-to-day management of the rental properties, including advertising the properties, communicating with renters and prospective renters via email and preparing the properties for the next rental. In addition to his full-time position in the HVAC business, Mr. Sezonov assisted in responding to emails and performed maintenance and repairs for the properties.
Taxpayers provided logs to support time spent on the rental activities. These logs were not contemporaneous and the hours were estimated based on rental agreements and emails. The logs were unclear as to who worked which hours. The Court determined that the estimated hours for Mrs. Sezonov fell short of the 750 hours test for real estate professionals. In addition, Mr. Sezonov failed to establish that he spent more time working in the real estate rental business than in his HVAC business. Accordingly, the rental activities were passive activities subject to the loss limitation rules under IRC Sec. 469.
Similarly, in Hakkak v. Commissioner, T.C. Memo 2020-46, a taxpayer who practiced law and also held ownership interest in LLCs that held rental real estate failed to establish that he qualified as a real estate professional when he failed to satisfy both the 50% test and 750 hours test. To demonstrate that Mr. Hakkak handled day-to-day management of the rental real estate, taxpayer provided handwritten calendars and documents such as emails, lease agreements, bank account and credit card statements, invoices, loan and insurance documents and property tax records. The Court concluded that taxpayer’s testimony at trial was vague, and the handwritten calendars lacked specificity as to the services performed and the hours works on each activity. In addition, the taxpayer did not provide the hours spent on his legal work, an activity in which he generated significant income. Accordingly, taxpayer was not considered a real estate professional under IRC Sec. 469.
Best Practices
The ability to claim passive activity loss deductions and obtain relief from the net investment income tax can result in significant tax savings. Therefore, keeping complete and accurate records that establish real estate professional status and material participation are essential. Keeping contemporaneous records on hours worked in and outside of one’s real estate business and detailing the specific services performed in each activity is the best way to ensure compliance with these rules. While contemporaneous records are not required, these cases demonstrate that taxpayers who prepare logs after the fact, based on estimates, often face difficulties in satisfying the necessary requirements.
1IRC Sec. 469.
2IRC Sec. 1411.
3IRC Sec. 469(c)(1) and (2).
4IRC Sec. 469(b).
5IRC Sec. 469(c)(7)(B). States may have different rules to determine whether a taxpayer qualifies as a real estate professional.
6IRC Sec. 469(c)(7)(C). Per Chief Counsel Advice 201504010, the term “real property trade or business” includes real estate brokers, but not mortgage brokers or other tangentially related businesses.
7Treas. Reg. Sec. 1.469-5T(f)(4).
8Zaid Hakkak, et ux., T.C. Memo 2020-46.
9Almquist v. Commissioner, T.C. Memo. 2014-40.
10Treas. Reg. Sec. 1.469-9(e).
11Treas. Reg. Sec. 1.469-5T(a). See also IRC Sec. 469(h)(2).
12IRC Sec. 469(h)(5).
13Personal services are health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, or any other trade or business in which capital is not a material income-producing factor. Treas. Reg. Sec. 1.469-5T(d).
14Treas. Reg. Sec. 1.469-5T(b)(2)(ii) and (iii).
15Treas. Reg. Sec. 1.1411-4(g)(7).
Our Current Issue Q3 2022:
IRS Has $80B Coming Its Way: Expectations for Enforcement
When Does Owning or Managing Rental Real Estate Make You a “Real Estate Professional?”
Act Now to Qualify for IRS Expanded Penalty Relief
Don’t Forget! 2020 Social Security Tax Deferral Payments are Due December 31st
Aretha Franklin Estate Settles with IRS
An In-Depth Look at the IRS Criminal Investigation Voluntary Disclosure Practice
