What does it mean to be a real estate professional? For many of our clients, the answer is straightforward: they’re landlords, property developers, contractors, and investors. From the perspective of the Internal Revenue Code, the answer also includes hours spent on these ventures.
Any real estate professional who doesn’t spend all his or her time on the day-to-day operations of the real estate business OR professionals who lease properties but also have another job should take note. The ability to deduct losses on the tax return may be affected.
Court Disallows Reported Losses
The recent U.S. District Court case Brendan G. Johnson et ux. v. United States; No. 2:19-cv-00674 decided that time spent studying for a real estate exam did not count toward satisfying real estate’s 750-hour threshold. As such, the defendant’s tax deductions for real estate business losses were disallowed on the basis that the taxpayer was not actually a real estate professional.
This matters because many taxpayers who lease property may find themselves in a similar situation and not be allowed to write off losses because their real estate business is considered a passive activity in the eyes of the Internal Revenue Code. Passive losses can only be used to offset passive income so many times; these passive losses are not deductible in the current year but must be carried forward.
Understanding Passive, Active, and Material Participation
Taxpayers who write off business losses on their tax return may be limited to what they can deduct depending on whether their participation is deemed passive or non-passive. To be non-passive, the taxpayer must materially participate.
Material participation is determined based on the taxpayer’s “regular, continuous and substantial” involvement in the trade or business. Generally, this requires meeting one of seven tests:
- Working 500 hours in the activity;
- Working more than anyone else in the activity;
- Working more than 100 hours in the activity and no one else worked more;
- The activity is a significant participation activity;
- The taxpayer materially participated any 5 of the past 10 years;
- The taxpayer works in a personal service activity and materially participated in any of the three prior years; and
- The taxpayer materially participated based on facts and circumstance.
Real estate activities are always passive unless the taxpayer qualifies as a real estate professional. However, there is a special allowance deduction of up to $25,000 depending on whether the taxpayer actively participates in the real estate activity. In general, active participation requires the taxpayer to own at least ten percent of the activity and make bona fide business decisions.
Qualifying as a Real Estate Professional
To qualify as a real estate professional, the taxpayer must perform at least 750 hours of services during the year on activities directly related to the real estate business and have at least 50 percent of their work in these activities. Closely held businesses can qualify as real estate professionals if at least 50 percent of the gross receipts for the tax year come from real estate activities.
After qualifying as a real estate professional, the taxpayer must also materially participate in each rental activity they are trying to deduct losses for. This typically needs to factor in grouping decisions, which should be consulted with a tax adviser.
At issue with the court case is how the 750 hours are calculated. That threshold, as the district court decided recently, cannot include professional development. In the case, the taxpayer credited the hours she spent studying for her state’s real estate exam. The court noted that licensure does not make a person or entity a real estate professional; time spent actively managing real estate does.
According to the IRS, qualified real estate activities include the following:
- Acquiring or converting real estate properties
- Renting or leasing
- Operating or managing real estate properties
- Real estate brokering
The Internal Revenue Code explicitly does not count certain hours in these activities including:
- Inflated hours;
- Investor type hours unless the taxpayer is involved in the day-to-day operations, such as reading and reviewing budgets, tax return preparation, reading real estate journals and organizing records;
- Time before the taxpayer owned the activity;
- Travel time; and
- Work not customarily done by an owner.
In this court case, the taxpayer was not permitted to treat herself as a real estate professional due to not meeting the hours requirement, and thus was disallowed from deducting passive activity business losses on her tax return – despite owning and operating several rental properties with her spouse.
Next steps for real estate professionals given the court decision are to ensure that they unequivocally meet the IRS standards for real estate professionals; that is, at least 750 hours throughout the year on qualified business activities. It is important to keep detailed records of time when you are a real estate professional. This can be done with calendars, Excel spreadsheets or any other method that tracks time related to real estate.
Further, each rental real estate property is treated separately, so taxpayers will need to prove material participation in each rental activity unless they elect to aggregate all rental real estate into one entity for purposes of determining material participation.
There are several complex tax rules to navigate regarding business loss deductions and real estate. A qualified advisor can help determine eligibility and recommend grouping strategies to combine rental real estate interests for purposes of achieving the business loss deduction.