In hopes of sheltering his wage income, A purchases a home and rents it at fair market value. Consider the following example:Įxample 1: In 1985, A, a doctor, earns wages from a medical practice of $300,000. Prior to passage of the Tax Reform Act of 1986, 3 tax shelters were readily available to any taxpayer with disposable income and the willingness to be a landlord.
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History of the Real Estate Professional Rules This article also discusses an important recent Chief Counsel Advice (CCA) in which the IRS revealed that it had previously misapplied a vital aspect of the real estate professional rules. While discussing each step, this article reviews case law, highlighting planning opportunities and traps for the unwary. This article seeks to clear up the confusion surrounding these rules by providing a step- by- step approach that tax advisers can use to determine whether a taxpayer qualifies as a real estate professional and, more importantly, if the taxpayer does qualify, whether his or her rental activities are treated as nonpassive. 469(c)(7) and the underlying regulations have confused taxpayers, tax advisers, IRS agents, and even Tax Court judges, leading to an inordinate amount of litigation during the 24- year history of the provision. The various terms of art, hours requirements, and quantitative tests imposed under Sec. Unfortunately, qualifying as a real estate professional is fraught with peril. 2Īs a result, it has never been more desirable for a taxpayer with rental activities to meet the qualification of a real estate professional. Thus, a taxpayer with rental incomenow has an incentive to qualify as a real estate professional: characterizing rental income as nonpassive to avoid imposition of the surtax. 1411 became effective, levying an additional 3.8% surtax on, among other items of investment income, all passive income of a taxpayer. On that date, the net investment income tax of Sec. 1, 2013, qualifying as a real estate professional suddenly became meaningful even to taxpayers with rental income. 469(c)(7) in 1993, 1 taxpayers with rental losses have sought to meet the qualification of a real estate professional to prevent those losses from being treated as per se passive, potentially allowing the losses to be used without limitation. 469(c)(7), however, overcomes the presumption that all rental activities are passive. Included in the definition of a passive activity is any rental activity, regardless of the taxpayer's level of participation.Ī taxpayer who meets the qualification of a real estate professional under Sec. 469 provides that losses from a "passive activity" may only be used to offset income from a passive activity, with any passive losses in excess of passive income for a tax year disallowed and carried forward to the next year. A safe harbor in such cases provides that 500 hours in the rental activity either in the tax year or in any five years (whether or not consecutive) of the immediately previous 10 years constitutes services in the ordinary course of a trade or business.Passive income, including from rental activities, is generally subject to the net investment income tax (provided other criteria are met) unless the taxpayer is a qualifying real estate professional and the income is derived in the ordinary course of a trade or business.However, the taxpayer may elect to aggregate all of his or her interests in rental real estate for purposes of determining material participation. A real estate professional taxpayer generally must establish material participation in each rental activity separately.A taxpayer qualifies as a real estate professional if (1) more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are in real property trades or businesses in which the taxpayer materially participates, and (2) hours spent providing personal services in real property trades or businesses in which the taxpayer materially participates total more than 750 during the tax year.469(c)(7) is not presumed to be passive and will be treated as nonpassive if the taxpayer materially participates in the activity. A rental activity of a taxpayer that qualifies as a real estate professional under Sec.
A passive activity generally includes any trade or business of a taxpayer in which the taxpayer does not materially participate and any rental activities of a taxpayer, regardless of the level of participation.
469, a taxpayer only may offset losses from a passive activity against income from a passive activity.
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