Why Does the IRS Deny Real Estate Losses as "Passive"/What is a "Real Estate Professional" under Tax Law?

A rental activity is generally treated as a per se passive activity.   Generally, “[r]ental real estate is any real property used by customers or held for use by customers… .” Temp. Regs. § 1.469-1T(e)(3(ii)(A); Regs. §1.469-1T(e)(3).  One exception to the rule that such activities are passive is found in IRC § 469(c)(7), which was added to the tax code in 1993.  Before 1993, real estate rentals were passive without exception.  Under Section 469(c)(7)(B), taxpayers do not fall under the general per se rule and are able to claim their losses without limitation if the taxpayers:

(1) Materially participate in real property trades or businesses form more than 750 hours and

(2) Perform more than half of all the personal services in trades or businesses in year in real property trade or businesses (this is not limited to rentals) in which there is material participation.

Under Section 469 of the tax code, “the term ‘real property trade or business’ means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”  IRS regulations say that, in the case of a joint return, the married couple will qualify as real estate professionals if one spouse separately meets the two-part test under Section 469(c)(7)(B).

The second part of the Section 469(c)(7)(B) test requires material participation in the real estate activity.  Regs. Secs. 1.469-9(b)(6), 1.469-9(c)(3), and 1.469-9(e)(1).  Under temporary IRS regulations currently in effect, taxpayers can establish material participation through any of the following seven tests:

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’ participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

With respect to the last test, regulations provide that, if it is a management activity, the taxpayer must have participated more than 100 hours, no other person must have spent more time managing the activity, and no other person may have been compensated for management of the activity.  Unlike with the two-part test, Section 469(c)(7)(B) allows the taxpayer’s spouse’s participation to be taken into account the to determine whether a taxpayer materially participates in the rental real estate activity under the 7 tests.