When to Deduct Passive Activity Losses for Rental Real Estate
February 08, 2022
By Eric Olsen, Helen Chen, Ashley Maxfield
The passive activity rules were designed to prevent investors from deducting passive losses from non-passive sources of income. The rules were enacted in 1986 and are contained in IRC Sec. 469 and apply to participation in a trade or business by investors who do not materially participate. While non-real estate businesses can be considered passive activities, the focus of this article is the application of the passive activity rules to rental real estate.
What Is a Passive Activity?
A passive activity is defined in IRC Sec. 469(c) as any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. However, a rental activity is by default a passive activity even if you do materially participate, unless you are a real estate professional.
While the rules are written in plain language, their application is anything but. The definition provides us two important items that need to be defined:
- Trade or Business
- Material Participation
Defining a Trade or Business
While “trade or business” is mentioned repeatedly throughout the IRC and Treasury Regulations, the term is not defined in either, instead, it is subject to an ever-evolving definition through case law.
The term was broadly defined in Commissioner v. Groetzinger, where the court determined that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity.” The IRS provides the following, unauthoritative definition, “The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services…”
Once an activity rises to the level of trade or business, as opposed to a hobby or an investment activity, we turn to the level of participation.
Defining Material Participation
Since materiality is conceptual, the IRS provided us the following seven tests for material participation in Treas. Reg 1.469-5T:
- The individual participates in the activity for more than 500 hours during the tax year;
- The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
- The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
- The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
- The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
- The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
- Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
Again, this provides guidance written in plain language with no plain application.
IRS Publication 925 provides that a taxpayer has materially participated if they satisfy any (not all) of the tests above, but not without the following caveats and provisions:
- Test seven cannot be used to claim material participation if you participated 100 hours or less
- Participation in managing the activity doesn’t count if:
- Any person other than you received compensation for managing the activity, or
- Any individual spent more hours managing the activity than you did (regardless of compensation)
- Participation is defined as any work you do in connection with an activity in which you own an interest, but
- Work done in connection with the activity cannot be treated as participation if:
- The work isn’t work that is customarily done by the owner of that type of activity
- One of your main reasons for doing the work is to avoid the disallowance of any loss or credit
- Work does not include any of the following which are treated as work done as an investor:
- Studying and reviewing financial statement or reports on operations
- Preparing or compiling summaries or analyses of the finances or operations for your own use
- Monitoring the finances or operations of the activity in a nonmanagerial capacity
- Work done in connection with the activity cannot be treated as participation if:
Deducting Passive Losses
Keep in mind that, without an election, the material participation tests apply separately for each activity. Those that successfully wade through the task of determining material participation and come away feeling absolute, deduct away (until you run into basis and at-risk limitations)! For those that emerge with uncertainty or ambiguity, we will look at the exceptions to the rules, including:
- Small Landlord Exception
- Qualifying Real Estate Professionals
- Election to Aggregate Rental Activities
- Grouping Election
Small Landlord Exception
The small landlord exception provides much less stringent participation requirements for deducting rental losses, but, as usual, it comes with stipulations.
IRC Sec. Section 469(i) provides that taxpayers with a MAGI (modified adjusted gross income) of less than $200,000 can deduct up to $25,000 of rental losses against non-passive income. The deduction begins to phase-out when MAGI exceeds $100,000. Deductibility of rental losses under this exception are based on active participation. Active participation is defined in the Code as at least 10% ownership by an individual not invested as a limited partner. The IRS provides examples such as approving new tenants, deciding rental terms, approving expenditures, etc.
Qualifying Real Estate Professionals
IRC Sec. 469(c)(7)(B) provides the exception for real estate professionals. One qualifies as a real estate professional if:
- Half of the personal services performed by a taxpayer in a taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Qualifying as a real estate professional allows for the deduction of, otherwise, passive losses without the need to meet the material participation standards for each activity separately.
Election to Aggregate Rental Activities
IRC Sec. 469(c)(7)(A) provides taxpayers yet another way around the limitation on passive losses. For those participating in multiple rental real estate activities, this section provides an election to treat all interests as one activity. Since the material participation rules apply to each activity, electing to treat multiple activities as one can help taxpayers meet the hours requirements when testing for material participation. This election does not come without drawbacks. Future dispositions and more complex record-keeping requirements should be considered.
A grouping election is similar to the election to aggregate in that it allows two activities to be treated as one for tax reporting. A key difference between these two elections is that a grouping election allows a nonpassive activity to be grouped with a passive activity other than a rental activity unless certain conditions apply. Regs. Sec. 1.469-4(c)(1) and 1.469-4(c)(2) provide for grouping legal entities if they constitute an “appropriate economic unit” and the tests for determining when that is the case.
Navigating the passive activity rules can be a daunting and complex task. While we have provided a general overview of the rules, and the exceptions, an in-depth analysis should occur for each activity.