Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive. Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.
This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.
For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously. Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation. There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.
Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules. If the test is met, the rental activity of a real estate professional is treated as non-passive. Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages. Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax. Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.
Am I a real estate professional?
The real estate professional must satisfy two tests:
- 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
- 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.
At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive. If there are interests in several real estate activities, this may be difficult to satisfy. To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances. In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.
The rental estate activity is owned by a trust. Can the trust be a real estate professional?
The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations. Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services. In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities. The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services. Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.
The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee. All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties. The LLC employed several people, some of whom were the trustees. The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.
Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.