Real estate professional status can provide relief from the Passive Activity Loss Limitation rules and the 3.8% Net Income Investment Tax (“NIIT”), resulting in significant tax savings.
Rental activities are per se passive. Passive Activity Loss (“PAL”) rules limit the ability to offset net losses from passive activities, like rental income, against other non-passive sources of income, such as 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. However, a real estate professional who materially participates in a real property trade or business is not subject to the passive activity loss limitation rules and may use rental losses to offset other sources of non-passive ordinary income.
Real estate professional test
To qualify as a real estate professional, a taxpayer must (1) perform more than 50% of services in real property trades or businesses (“50% test”); (2) perform more than 750 hours of service in real property trades or businesses (“750 hours test”); and (3) 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, and leasing or brokerage trade or business.
To substantiate time spent, the IRS requires detailed records to support the hours worked in real estate in relation to those worked in other businesses. 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. These means 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. Post-event "ballpark guesstimates" or unverified, undocumented testimony are insufficient.
The 50%- 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 business.
Material participation is determined separately for each rental property. For taxpayers with several rental properties, it may be difficult to meet the material participation test on a separate property basis. Therefore, the IRS permits taxpayers to make an election to treat all interests as a single rental real estate activity. The aggregation election is made by attaching a statement to a timely filed tax return. Generally, the election is binding until revoked and covers future years. Rev. Proc. 2011-34 provides relief for a late election if reasonable cause is established.
To be considered a “material participant,” a taxpayer must satisfy at least one of the following:
- Work more than 500 hours in the activity. Unlike under the 50%- and 750-hours tests, participation of both spouses is counted for material participation. Participation by children or employees is not counted.
- Do substantially all the work in the activity.
- Work 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.
- Materially participate in the activity in any five of the prior 10 years.
- Materially participate in a personal service activity for any three prior years.
- Participate in the activity on a regular, continuous and substantial basis during such year.
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 the NIIT. However, the taxpayer must meet the definition of the real estate professional test as described above, rental income must be derived in the ordinary course of a trade or business, and the rental activity must not be 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 a year in any five of the previous 10 years, whether consecutive—a safe harbor rule deems rental income associated with the activity to be derived in the ordinary course of business.
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 Dunn v. Commissioner, T.C. Memo 2022-112, a husband and wife owned rental properties individually and through a real estate development LLC. Their real estate business hired outside consultants to collect rents, show apartments and manage the property it held. The taxpayers directly managed all other properties. Taxpayers kept two logs: one for the property held by the real estate LLC and one for the individually managed properties. Taxpayers did not make an election to aggregate their rental real estate activities into a single activity. Taxpayers also held full-time jobs as computer specialists.
The Tax Court determined that taxpayers failed to qualify as real estate professionals. The logs provided were vague and misleading on time spent and who performed what tasks. With full-time jobs outside of real estate, each taxpayer was also unable to prove it met the 750 hours test or that their participation in real estate activities was not less than their participation in other activities. The Tax Court also upheld a 20% accuracy-related penalty for substantial understatement of tax.
In Sezonov v. Commissioner, T.C. Memo 2022-40, a husband and wife owned an HVAC business and rental properties and claimed they qualified as real estate professionals, but 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, 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 on the properties.
Taxpayers provided logs to support the 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 Tax 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 held ownership interest in LLCs that held rental real estate failed to establish that he qualified as a real estate professional because he failed to satisfy both the 50% test and 750 hours tests. To demonstrate that the taxpayer handled day-to-day management of the rental real estate, the taxpayer provided handwritten calendars and documents (e.g., emails, lease agreements, bank account and credit card statements, invoices, loan and insurance documents, and property tax records). The Tax Court concluded that the 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, the 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, it is essential to keep complete and accurate records that establish real estate professional status and material participation, along with consideration of an aggregation election. 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. While contemporaneous records are not required, the above cases demonstrate that taxpayers who prepare logs after the fact and based on estimates often face difficulties with satisfying the necessary requirements.
Miri Forster is a partner and national leader of Eisner & Amper’s tax controversy & dispute resolution group. She specializes in providing tax dispute resolution services to public and private corporations, partnerships and high-net-worth individuals on a wide range of technical and procedural issues. Stephanie Rabeau is a tax manager in the firm's tax controversy & dispute resolution group. Her responsibilities include resolving tax disputes and challenges and conducting tax research, particularly with high-net-worth clients.