Since 1994, special rules have applied to real estate professionals. Real estate professionals can deduct all of their losses from rental real estate activities in which they materially participate. The reason for this is that when a real estate professional materially participates in his or her rental property, the property is considered to be an "active" activity and does not fall under the passive activity limitations. An individual is a real estate professional if:
• more than one-half of the personal services he or she performs in trades or businesses during the taxable year are performed in real property trades or businesses in which he or she materially participates, and
• he or she performs more than 750 hours of services during the taxable year in real property trades or businesses in which he or she materially participates.
Real estate professionals include those individuals involved in construction, development, acquisition, conversion, rental operation, managing, leasing, and brokering.
Rental property owners that meet both of the above criteria can deduct losses for each property in which they materially participate. However, the material participation criteria can be extraordinarily complex. An example of an easy way to meet the material participation rule is an owner that operates and manages their property and no one else spends more time working on the property. That owner is a material participant. On the other hand, if an owner hires a property manager to operate and manage their property, the owner will probably not be a material participant in that property. In addition to the above two criteria, the following three rules are generally applied in determining whether a rental property owner is a material participant in a particular property.
• The owner participates more than 500 hours in the property.
• The owner participates more than 100 hours, but less than 500 hours, and this participation is not less than the participation of any other individual.
• The owner's participation constitutes substantially all of the participation of all parties associated with the property.
These rules are applied to each rental property separately. For example, assume a rental property owner has the following three properties:
1. Single family residence for which they perform all management.
2. A 12 unit apartment building with an on-site manager who spends 10 hours per week managing the property. The owner spends 400 hours during the year paying bills, approving new tenant applications and approving necessary repairs.
3. A 50 unit apartment building with an on-site manager who spends 30 hours per week managing the property. The owner spends 550 hours during the year paying bills, approving new tenant applications and approving necessary repairs.
The above owner qualifies as a real estate professional because: 1) he has no other business activities and spends over one-half of his personal service hours on real estate activities. 2) He spends more than 750 hours in the rental management business. The first property qualifies as an active rental property since the owner spends substantially all of the time required on the property. The second property does not qualify as an active rental, since the owner spends less than 500 hours on the property and another person spends more time than the owner on the property. The third property qualifies, even though another person spends more time than the owner, because the owner spends more than 500 hours managing the property.
Another consideration is a special election to treat all rental activities as a single rental activity. This election allows the owner to aggregate his or her activities relating to all properties to determine material participation. This election is binding for all future years, so it is must be considered carefully. This election can be helpful for loss generating properties. However, income generating properties, where the taxpayer would like the income to be passive, are also classified as active. This may not be good for the taxpayer who has accumulated passive losses from previous years.
Another factor to consider, prior to making this election, is that rental properties that come under these rules are no longer passive. This means that gain on sale of a property is not passive income. This can be a big trap since accumulated passive losses, from other properties, can not be used to offset the gain from an active rental property. Also, an election to treat all properties as a single activity is dangerous if there are substantial prior losses. Disposition of one property does not automatically free up losses from that property because the entire activity has not been sold.
With proper planning these rules can provide tremendous benefits for real estate professionals. The bottom line is that the special rules for real estate professionals are like the proverbial bowl of cherries . . . you have to look out for the pits.
