In order to understand what this designation means we need to look back in history to see why it is so important. Prior to 1986, real estate “tax shelters” were used to reduce the taxable income of individuals who were not engaged in the business of real estate. Anyone willing to be a landlord or willing to invest in tax shelter investments were able to use tax losses from real estate to reduce their income or potentially completely erase it in a given year. Congress, recognizing what they deemed an abuse of the system, enacted a series of regulations culminating in the Tax Reform Act of 1986 (the Act). This Act created a new Internal Revenue Code Section 469 to deal with passive activities. To put it succinctly, the aforementioned individual would no longer be allowed to deduct the losses from these tax shelters.
The Act designated rental activities as inherently passive activities. Therefore, losses from rental activities can only offset income from other passive activities. Knowing that there is an entire industry based around real estate, Congress did carve out a special set of rules for those individuals whose business is real estate. These people were designated as real estate professionals and could deduct the passive losses against other non-passive income because with this designation, real estate would not be treated as passive. However, these professionals had to meet a strict set of requirements and had to achieve a level of “material participation” in order to qualify.
In order to materially participate in an activity, it must be regular, continuous, and substantial. Otherwise, the activity would be considered passive by nature. For example, if you own a marketing business and that is your sole source of income it can be confidently said that you materially participate in that business. If in the same situation you happen to also own a duplex that you rent out, that rental activity, if it generates a loss, cannot be used to offset your marketing income because you do not materially participate in that rental activity. So the question becomes, how do I materially participate in an activity?
The Seven Ways to Achieve Material Participation
- You participate in the activity for more than 500 hours during the year.
- Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year.
- Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than you.
- The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours. [A significant participation activity is generally a trade or business activity (other than a rental activity) where you spend more than 100 hours during the year but do not qualify for material participation based on any of the other ways to achieve material participation.]
- You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years.
- For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or:
- A generic facts and circumstances test which is subjective.
Based on the seven factors above, there appears to be several ways to meet the threshold to be able to say that rental activities are non-passive. However, as previously stated, real estate professionals have to meet a higher threshold before they can get out of the passive activity designation. Before we determine that, we must know the definition of a real property trade or business (RPTB). You can only be a real estate professional if you work in a RPTB. Those are business activities in the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property. This is a very expansive list and can encompass a lot of different scenarios for qualifying as a real estate professional.
Before continuing, we should note that hotels/motels, storage spaces, dormitories, or property where the average customer use is less than seven days is not considered a rental activity.
For illustrative purposes, assume that you are in one of those businesses. Your next step is to determine your material participation based on one of the previously mentioned seven ways. Assuming you meet the 500-hour participation requirement, you must then elevate your threshold to a higher 750-hour requirement and more than 50-percent of your working time spent test. This means that if you work at least 750-hours and more than half of your working time is spent in a RPTB you could pass. Therefore, you would think that you can achieve real estate professional status – and you would be correct. You’ve met the requirements and you can happily deduct as much rental losses as you have EXCEPT for one small, minor, and inconvenient next step.
The final step is to determine your level of participation ONLY in rental activities. This means if you’re a real estate agent or a contractor who owns a couple of rental properties on the side you must be able to show that you meet the increased level of material participation in those activities specifically. You qualify as working in a RPTB but you do not qualify as a materially participating real estate professional with respect to rental activities only. Therefore, you would fail the test and your rental activities would continue to be treated as passive. However, if you work solely in the rental of real property then you would pass this last test.
By a technicality you must meet the 750-hour requirement for each individual rental activity. If you only have a few rentals it would become nearly impossible to work 750-hours in each rental. Knowing this, the US Treasury released regulation 1.469-9 which allows you to group all of your individual rental activities together into one single activity. So as long as the combined activities total at least 750-hours of participation and passes the more than 50-percent test you would qualify.
If you made it this far, congratulations, you are a real estate professional!
There are numerous nuances to the real estate professional designation and specifically the material participation threshold. Consult your tax advisor for your unique situation.