You may be familiar with the Real Estate Professional election, which allows qualified taxpayers in a real property trade or business to deduct their rental real estate losses without limitation to their total passive income. Examples of these types of trades or businesses are real property development, construction, rental, management, leasing, and brokerage.
While the election must be made in order to aggregate all of one’s rental real estate activities, as well as for such losses to be treated as non-passive, the real estate professional must also continue to achieve material participation in their rental real estate activities. Let’s look at a U.S. District Court case, recently decided in appeals, that illustrates this requirement.
In Gragg v. United States, Dolores Gragg was a real estate agent, one of the real property trades or businesses that qualifies one to be a real estate professional. Despite not having made the election to be treated as a real estate professional, Dolores treated the losses from her two rental real estate investments as nonpassive for 2006 and 2007. Her tax returns were selected for audit, and the IRS challenged the nonpassive treatment of her losses. By not making the real estate professional election, and also by not maintaining complete and accurate time records to document her level of participation, she had the misfortune of losing this case.
The Passive Loss Rules and Real Estate Professional Election
At one point in time, taxpayers had the ability to deduct losses from their investments without limitation. A byproduct of this ability was the creation of tax shelters, often in the form of carefully structured real estate investments, which were widely abused by taxpayers serving as mere capital investors and nothing more. To eliminate this abuse, Congress enacted the passive activity loss rules in 1986, the purpose of which was to limit deductions of passive losses to one’s total passive income. Any excess passive losses are carried forward to future years, and can be deducted in full in the year the investment is completely disposed of. These rules put in place the requirement for taxpayers to achieve certain levels of participation in their activities in order to qualify for a deduction of such losses.
By definition in the Internal Revenue Code, rental real estate is a passive activity. However, in 1993, Congress recognized that certain individuals materially participate in trades or businesses involving real estate, and that it would be unfair for those individuals to limit their rental real estate losses to their total passive income for the year. With that, the real estate professional exception to the general rule was created, and was designed for individuals that clear two hurdles:
- More than one-half of their personal services performed in trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.
By making the real estate professional election, all of the taxpayer’s rental real estate activities become aggregated into one activity. It’s important to note that your participation in other types of trades or businesses engaged in for profit generally cannot be grouped with rental real estate activities; a separate grouping election must be made for those types of activities.
Material participation (and proof thereof) is key
When it comes to material participation, there are seven tests to determine if taxpayers’ activities should be treated as passive or nonpassive. These tests apply to both rental real estate holdings as well as business activities engaged in for profit. We explored these seven tests in a previous Insights article, which can be found here.
The issue at hand in the Gragg case was whether Mrs. Gragg, a real estate professional, remained subject to the material participation requirement that would apply to other situations where a taxpayer incurs passive losses. As the court pointed out in its opinion, the law specifically states that the taxpayer must materially participate in each activity in order to avoid passive loss treatment. Therefore, merely qualifying as a real estate professional, whether or not the real estate professional election is made, does not inherently result in your rental real estate losses becoming deductible without limitation to one’s passive income.
By not making the real estate professional election, your participation in each rental real estate activity must be measured separately for each of your activities. Accordingly, Mrs. Gragg made it more difficult for herself to qualify as materially participating in all of her rental real estate activities. In other words, it is easier to achieve 500 hours of participation in four different activities grouped into one activity, rather than 500 hours separately for four different activities not grouped together.
Also hurting her situation is the fact that Mrs. Gragg did not maintain contemporaneous records of her participation in the rental real estate activities. She attempted to reconstruct these records by providing after-the-fact estimates of the number of hours she participated in her rental real estate activities. Her records consisted of undated notes stating that participation was approximately 100 hours, 200 hours, etc., for various duties involved with managing and maintaining the rental properties. The court interpreted her records as being very vague and ambiguous, and ultimately rejected this evidence on account of the records being unreliable and unsupported by contemporaneous records.
If you are a real estate professional and own rental real estate, here are some things you can learn from the Gragg case:
- Although you may qualify to make the real estate professional election, first consult with your tax advisor to determine whether you should consider making this election on your tax return. Once made, the election is irrevocable unless permission is granted by the IRS, and your individual situation may not give rise to a favorable outcome once the election is made. For instance, if you have passive loss carryovers, they could be trapped until you dispose of all your rental real estate activities—clearly not a favorable result.
- Even if you are a real estate professional and have made the real estate professional election, you must still clear the hurdle of material participation in your rental real estate activities for each year. Refer back to the seven tests for material participation, and ensure you can prove you meet at least one of those tests. It will be easier to meet this test if you are a real estate professional, since your participation in all of your rental real estate activities will be counted together, rather than separately.
- Make sure you are keeping a contemporaneous log of your time spent on those activities. The IRS and courts will be much more likely to accept these records than those that are constructed after-the-fact. Post-hoc construction of such records often depends on ballpark estimations of participation, which does not serve as a reliable basis for proving material participation.
Joseph Wutz is a manager based out of our Buffalo, NY office.