While designation as a Real Estate Professional may be only a matter of semantics in the business world, it can have very real consequences in the world of taxation. Real Estate Professional is a designation defined by the Internal Revenue Service (IRS) that can determine whether a taxpayer’s real estate activity is treated as an active or passive activity. Beginning in tax year 2013, the distinction between active and passive became particularly relevant due to the 3.8% Medicare surtax on investment activities.
By default, real estate rental activities are considered to be passive; and under Internal Revenue Code (IRC) Sec. 469, losses from passive activities can only be used to offset income from other passive activities. While unused losses may be carried forward, the taxpayer must postpone the benefits of passive losses until passive income is available to offset or until the activity is fully disposed.
An exception is permitted to the passive treatment of real estate activities for taxpayers that meet the IRS definition of a Real Estate Professional. To qualify, the following requirements must be satisfied by the taxpayer (or at least one spouse if a joint return is filed):
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year must involve real property trades or businesses in which the taxpayer (or the taxpayer’s spouse) materially participates; and
- The taxpayer must perform more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer (or the taxpayer’s spouse) materially participates.
The first requirement makes it very difficult for a taxpayer working full-time as an employee in an unrelated field to qualify. However, the requirement can be met if the taxpayer is employed full-time in a real property trade or business and the taxpayer owns more than a five-percent interest of the employer.
Many taxpayers have lost their classification as a real estate professional because they could not prove that they met the 750-hour requirement. Although Treasury Regulation §1.469-5T states:
“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.”
The more detail a taxpayer can produce, the better. Courts have challenged evidence considered “reasonable means” by taxpayers and have disallowed real estate losses due to lack of substantiation of the time spent in the activity.
The remainder of the second requirement involves material participation. A summary of the seven requirements outlined in Code Sec. 469(h) are as follows:
-The activity is a significant participation activity and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
-The activity is a personal service activity and the individual materially participated in the activity for any three taxable years; or
It is important to note that the passive activity exception for taxpayers is applied as if each real estate activity is a separate activity. However, a grouping election is available that allows the taxpayer to treat all activities as a single activity in order to meet the material participation requirements.
The regrouping of activities grouped in a prior year is normally not permitted. The IRS, however, is allowing taxpayers to regroup activities in 2013 or 2014 to lessen the burden of the additional Medicare tax. In addition, taxpayers may regroup activities in the first year beginning after December 31, 2013 in which the taxpayer's modified adjusted gross income exceeds the applicable Medicare tax threshold and the taxpayer has net investment income.
As indicated above, determining whether a taxpayer qualifies as a Real Estate Professional requires accurate record keeping and professional judgment. Accordingly, individuals with significant real estate activity should consult a professional with specific and extensive real estate experience to determine the best approach to lessen the tax burden and maximize the benefits of working and investing in real property.
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 A significant participation activity is one in which the taxpayer participates more than one hundred hours during the year but does not meet any of the other six requirements.
 A personal service activity involves any profession where capital expenditures are not the major source of income production (health care, law, engineering, architecture, accounting, consulting, etc.)