Real estate rental activities are considered passive activities for all taxpayers except qualifying real estate professionals. Passive losses can be utilized only to offset passive income. To qualify as a real estate professional, the taxpayer must meet the following criteria:
- More than 50% of personal services performed by the taxpayer in ALL trades or businesses during the tax 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 tax year in real property trades or businesses in which the taxpayer materially participates.
If the above test is met, then any rental real estate activity in which the taxpayer materially participates is not a passive activity. Tests for determining material participation include (among others):
- Participation for more than 500 hours during the tax year in the activity.
- Participation constituting substantially all of the participation in the activity at the particular real estate business.
- Participation of more than 100 hours during the tax year, which is at least as much as any other person engaged in the activity at the particular real estate business.
- Engaging in several activities that individually do not qualify as material participation, but the taxpayer spends more than 100 hours in each activity and the total hours during the year in these activities exceed 500 hours (“significant participation activity” test).
- Based on the facts and circumstances, the taxpayer has participated in the activity on a regular, continuous and substantial basis; however, the taxpayer must participate for more than 100 hours in the activity.
In connection with the above, a real property trade or business means any trade or business involved in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. Real estate financing is not considered a real property business.
There are special rules, beyond the scope and purpose of this article, which cover situations in which a taxpayer may have multiple rental real estate businesses which allows for the taxpayer to group these rental activities into one activity to assist in meeting the criteria. Similarly, when both spouses engage in real property trades or businesses, there are favorable spousal participation rules.
At times, the IRS will question a taxpayer’s assertion that he/she qualifies as a real estate professional. Upon audit, the taxpayer bears the burden of substantiating that his/her participation in the real estate activities meets all the requirements.
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, though extremely helpful, are not required if the extent of participation can be established in other ways. Other reasonable methods include the identification of services performed and the approximate number of hours spent performing these services over a period of time, based on appointment books, calendars or narrative summaries.
While the tax regulations are not specific concerning the records to be maintained, they by no means allow post-event ballpark “guesstimates”. Thus, preparing documentation shortly before examination or at the time of audit is insufficient. It is therefore strongly urged that the taxpayer keep a dated, contemporaneous log of activities and the actual time spent. This should be done for each separate activity that the taxpayer engages in. By doing this, the taxpayer can generate sufficient evidence to defend against an IRS audit. Finally, the documented time should be credible. Stating that it took 10 hours to change three light bulbs in a rental apartment would virtually end all hopes of persuading the IRS that the taxpayer has presented sufficient substantiation of his/her participation in the activity.
The rules regarding qualifying as a real estate professional are complex and we would be happy to discuss them with you at length. Contact your Friedman LLP professional for further information.