As we’ve discussed here, here, and here, rental real estate activities are considered passive by default. Passive losses, of course, may generally only offset passive income. Unless, that is, you qualify as a “real estate professional” under Section 469(c)(7), in which case you can deduct rental losses in full against nonpassive income.
In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B). The taxpayer must satisfy both of the following tests:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates.
- Such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
Furthermore, Section 469(c)(7)(A)(ii) provides that each interest owned by the taxpayer in rental real estate will be treated as a separate activity unless the taxpayer makes an election to treat all rental real estate activities as a single activity.
What is the significance of the underlined portion of the text? In this author’s view, it is these two concepts that — when read in conjunction — have been misinterpreted by the IRS and the Tax Court in recent years. Based on a case settled yesterday, however, the courts may finally be getting it right.
Allow me to clarify…
In several cases, the IRS has taken the position that if a taxpayer owns multiple rental properties and fails to make the election to aggregate the activities, the 750-hour prong of the real estate professional test must be applied to each separate rental property in order to determine if the taxpayer is a real estate professional.
Now, I’m not the smartest man on the planet, but this seems rather silly. Here’s why:
Say I own one rental property. I spend 1,000 hours of my year managing the rental property, and also meet the “more than half” prong of the real estate professional test. The 1,000 hours I spend not only means I materially participate in my activity under Section 469, it also means I pass the 750 test. I’m a real estate professional. Good for me.
Now, assume instead I own 5 rental properties and spend 200 hours per year on each property, which is more than anyone else spend managing the properties. However, I neglect to elect to aggregate the properties. As a result, the IRS and the Tax Court would have you believe that I must now pass the 750 hour test for each individual property, which I have not done. The fact that I materially participated in each property, by virtue of the 3rd test of Treas. Reg. 1.469-5T (>100 hours and more than anyone else), does nothing for me in the government’s eyes, as I did not meet the 750 mark on a property by property basis.
The Tax Court ruled this way in Jahina, a case settled in 2002. I can remember reading the decision shortly after it was published, and thinking the result seemed unduly harsh. The Tax Court’s reasoning begged the following questions:
Isn’t the purpose of the real estate professional exception to remove those individuals who devote the majority of their time to real estate trades or businesses from having their rental activities treated as de facto passive?
Why would a taxpayer, who instead of spending 1,000 hours on one property spends 250 hours on five separate properties, be treated as less of a real estate professional merely for failing to make an election?
The answer, of course, is that they shouldn’t be treated any differently.
It has always been my take that the IRS and the Tax Court have misinterpreted the requirement that the taxpayer performs more than 750 hours of services in real property trades or businesses in which the taxpayer materially participates. I have never believed that this requirement necessitates electing to aggregate the activities or else be left trying to meet the 750 hour test for each individual property.
Based on my reading, even if a taxpayer fails to make the election, they should be able to satisfy the 750-hour test on an aggregate basis. I believe the statute requires a two-part examination of the taxpayer’s activities:
First, the taxpayer must identify the activities in which he materially participates. This material participation can be satisfied under any of the seven tests provided for in Treas. Reg. 1.469-5T.
After identifying those activities in which the taxpayer materially participates, the total hours spent on those activities must exceed 750 hours.
Harkening back to my previous example, if a taxpayer spends 200 hours on each of 5 properties and satisfies one of the material participation tests for each property, then even if failing to make an election to aggregate the activities, the total hours spent of 1,000 on activities in which the taxpayer materially participates will pass the 750 test.
As clarification, if, for argument’s sake, the taxpayer failed to meet the material participation test for one of the properties (perhaps due to another individual spending more time on the property), then the taxpayer would remove that property from the computation for purposes of the 750 test. Instead, the taxpayer would look to the four properties in which they did meet the material participation tests, total the 800 hours, and still meet the test.
By approaching the statutory language in this manner, you avoid the rather anomalous result of having two taxpayers — working equally in the real estate field — being treated differently simply because one failed to make an election.
Yesterday, however, the Tax Court decided Harnett v. Commissioner, T.C. Memo 2011-191, another “real estate professional case.” In Harnett, the taxpayer owned over a dozen properties. The taxpayer failed to meet the 750 test and did not qualify as a real estate professional because the taxpayer could not prove the hours test was met with a contemporaneous log, and the court did not find his testimony credible. But that’s not what’s important. What is important is that the Tax Court made no mention of an election to aggregate the activities, and in performing it analysis, the court combined the hours spent by the taxpayer on only those properties in which it appeared the taxpayer materially participated. Perhaps I’m being overly optimistic, but it would appear the Tax Court may now be interpreting the 750 hour test correctly.
So in essence, while Harnett may have lost the battle, future taxpayers may win the war.