The significance of qualifying for real estate professional tax status for investors with rental activities as a part of their portfolio is difficult to overstate. By meeting this definition and establishing material participation in rental activities, taxpayers can make their rental activities nonpassive. This allows them to use rental losses without limitation and avoid the net investment income tax on rental income. However, qualifying as a real estate professional can be complex, and it is best to engage a qualified CPA to help navigate this process effectively.
Step 1: Group Your Real Estate Activities
The law wants to ensure that the benefits of being a real estate professional are limited to those who spend most of their time in the real estate industry. So, the taxpayer will need to show that they are actively involved in a real estate business.
The rules give one a chance to qualify as a real estate professional. A real estate business can be one or more trades or businesses, as described in section 469(c)(7). This means that if the taxpayer is involved in two or more of the 11 real estate activities listed in the law, they can group them together and count them as one business. Why is this helpful?
In Step 2, the taxpayer needs to show that they are significantly involved in real estate businesses. This is called “material participation”. By grouping their activities into one business, they can add up all the hours they spend on them. The more hours they can count, the more likely they are to meet the material participation standard. So, grouping can increase their chances of qualifying as a real estate professional.
Step 2: Identify the Businesses You’re Actively Involved In
Next, the taxpayer needs to show that they are actively involved in the real estate businesses they identified in Step 1. Only the time they spend on these businesses where they are actively involved will count towards the two tests of Sec. 469(c)(7)(B).
To be considered actively involved in a real estate business, they need to be regularly and substantially involved in its operations. There are seven tests that can be used to meet this standard. They will be considered actively involved in a business if they:
Spend more than 500 hours on the activity in the tax year.
Their involvement in the activity for the tax year is almost all of the involvement in that activity of all individuals (including those who don’t own interests in the activity) for the year.
Spend more than 100 hours on the activity in the tax year, and their involvement in the activity for the tax year is not less than the involvement in the activity of any other individual (including those who don’t own interests in the activity) for the year.
The activity is a significant participation activity for the tax year, and their total involvement in all significant participation activities during the year exceeds 500 hours.
They were actively involved in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year.
The activity is a personal service activity, and they were actively involved in the activity for any three tax years (whether or not consecutive) preceding the tax year.
Based on all of the facts and circumstances, they are involved in the activity on a regular, continuous, and substantial basis during the year.
There are several important things to consider when determining if the taxpayer is actively involved in the real estate business. First, time spent as an employee doesn’t count unless they are a 5% owner in the employer. Time spent as an investor in a real estate business—such as studying and reviewing financial statements, preparing summaries of the finances or operations, or managing the finances of an activity in a nonmanagerial capacity—doesn’t count towards active involvement unless they are directly involved in the day-to-day management of the business. Also, if they hold an interest in a real estate business through a limited partnership interest, you can only show active involvement by meeting the first, fifth, or sixth tests of the seven tests described above.
When determining active involvement, a married taxpayer must count any hours worked by his or her spouse, even if the spouse doesn’t own an interest in the business or if no joint return is filed. While this rule can be helpful because it makes it more likely the taxpayer is actively involved in the real estate business, it can also be a trap in the real estate professional context, as discussed below in Step 3.
The courts have repeatedly said that the IRS is not required to accept a noncontemporaneous “ballpark guesstimate.” As will be discussed in Step 4, the flexibility given to taxpayers to record hours retroactively often causes problems.
Step 3: Total the Hours From Real Property Trades or Businesses in Which the Taxpayer Materially Participates
Next, the taxpayer adds up the hours they’ve spent in their real estate businesses where they play a significant role. If married, the taxpayer can include their spouse’s hours to determine if they significantly participate in the business. However, to pass the two tests of Sec. 469(c)(7)(B), the taxpayer can only count their own hours.
Step 4: Apply the Hours From Step 3 to Two Quantitative Tests
Test 1: More than Half of Total Hours?
Does the taxpayer’s hours from Step 3 make up more than half of all the hours they worked in all businesses during the year? This first test is for those who spend most of their work hours in real estate businesses where they actively participate. It’s tough for someone with a full-time job outside of real estate to pass this test. The IRS and courts are skeptical when someone with a full-time non-real estate job claims to have spent more time on real estate activities. For example, a full-time research associate claimed to have worked more hours managing his rental properties than at his job. The court didn’t believe his records and ruled he didn’t qualify as a real estate professional. However, a full-time boat pilot did convince the court he spent more time on his construction work and rental properties, thanks to credible logs and witness testimonies.
Test 2: Does the taxpayer’s hours from Step 3 exceed 750?
This second test requires the taxpayer to work 750 hours in real estate businesses where they actively participate. This stops someone who only has real estate businesses (and so always passes the first test) from qualifying as a real estate professional if they spend minimal time on these businesses.
Like the first test, poor record-keeping often leads to failure. For example, hours spent “on call” don’t count, nor does owning many valuable properties. However, a veteran who convincingly described his daily routine which totaled over 750 hours did pass. Similarly, a taxpayer who didn’t initially include travel time between her properties was deemed to have met the test.
Step 5: Be Actively Involved in Each Rental Activity, or Combine Them All
If the taxpayer passed the tests in Step 4 and are considered a real estate professional, they still need to show active involvement in each rental activity to make them nonpassive.
Active involvement means being hands-on in managing the rental properties. They can count hours spent managing them, even if they work for a real estate management company that doesn't own rental properties directly. However, they can only count time spent managing their own rental properties.
As a real estate professional, they have the option to combine all your rental activities for simplicity. But this choice can be tricky and has caused confusion in the past. If they choose to combine them, the taxpayer needs to make a formal election, stating that they are a qualifying real estate professional and that they are combining all their rental activities. Simply listing them together on the tax form is insufficient. They make this election by filing a statement with their tax return for the year.
Conclusion
The significance of qualifying as a real estate professional for taxpayers with rental activities is an important distinction when investing directly in real estate. Following these rules requires the help of a trained accountant with experience in this area of the tax code. We would be happy to make an introduction.
Sources and Disclosures
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