When Does Owning or Managing Rental Real Estate Make You a “Real Estate Professional?”

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 nonpassive sources of income (like 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 PAL limitation rules and may use rental losses to offset other sources of nonpassive ordinary income.

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.

Real Estate Professional Test

To qualify as a real estate professional, a taxpayer must satisfy the following tests:

  1. Perform more than 50% of services in real property trades or businesses (“50% test”), and
  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, leasing or brokerage trade or business.
The IRS requires detailed records to support the hours worked in real estate compared to those worked in other business. 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. Reasonable means for purposes of this paragraph 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 may be insufficient.

The 50% test 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 unless the taxpayer elects to treat all interests as a single rental real estate activity. As a general rule, the election is binding until revoked and covers future purchases.

To be considered a “material participant,” a taxpayer must satisfy at least one of the following:

  1. Taxpayer works more than 500 hours in the activity. Unlike the 50% and 750 hours tests, participation of both spouses is counted for material participation. Participation by children or employees is not counted;
  2. Taxpayer does substantially all of the work in the activity;
  3. Taxpayer works more than 100 hours in the activity and no one else works more than the taxpayer (including non-owners or employees);
  4. 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;
  5. Taxpayer materially participates in the activity in any five of the prior ten years;
  6. Taxpayer materially participates in a personal service activity for any three prior years; or
  7. Based on all facts and circumstances, taxpayer participates 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 NIIT if:

  1. The taxpayer meets the definition of real estate professional test as described above, and
  2. Income is derived in the ordinary course of a trade or business and the rental activity is not 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 per year in any five of the previous ten years, whether or not consecutive), a safe harbor rule deems rental income associated with the activity to be derived in the ordinary course of business.

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, keeping complete and accurate records that establish real estate professional status and material participation are essential. 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 with these rules. While contemporaneous records are not required, these cases demonstrate that taxpayers who prepare logs after the fact, based on estimates, often face difficulties in satisfying the necessary requirements.

The information presented here should not be construed as legal, tax, accounting, or valuation advice. No one should act on such information without appropriate professional advice and after a thorough examination of the particular situation.