Are You a “Real Estate Professional?”

Being a real estate professional can provide significant tax benefits. Taxpayers who qualify may be able to prevent the application of the passive activity loss (“PAL”) limitation rules while the rental income may be exempt from the 3.8% net investment income tax (“NIIT”). However, the requirements to qualify as a real estate professional are stringent. Taxpayers may lose out on these benefits due to inadequate recordkeeping or a failure to make a timely aggregation election to group all rental properties together. They may also simply not understand the definition of a “real estate trade or business” or the number of hours needed to qualify for this coveted status. It is vital for taxpayers who wish to take advantage of this status to understand the rules and how to gain the benefits they are seeking.  

Passive Activity Loss Rules 

Most taxpayers who are considered real estate professionals are those who own properties and rent them out throughout the year. Under the IRC, rental activities, and therefore the income received, are presumed to be passive. IRC Sec. 469 sets out the PAL rules, which limit the taxpayer’s ability to offset net losses from passive activities against non-passive sources of income, like wages. PALs may be deducted only to the extent of a taxpayer's passive activity income. The remainder is carried forward to be used when the passive activities generate a gain or upon the disposal of the property or activity. Fortunately, a real estate professional who “materially participates” in a real property trade or business is not subject to these PAL limitation rules and may use rental losses to offset other sources of nonpassive ordinary income. 

Net Investment Income Tax 

The Net Investment Income Tax, as the name implies, applies to any income that is derived from “investment” income, such as interest, dividends, royalties, or rent. However, a real estate professional may not be subject to the NIIT provided that: 

• the taxpayer meets the definition of “real estate professional” as described below,
• rental income is derived in the ordinary course of a trade or business, and  
• the rental activity is not considered a passive activity under IRC. Sec. 469.  

If the real estate professional participates for more than 500 hours in the current taxable year, a safe harbor rule under Treas. Reg. Sec. 1.1411-4 deems rental income associated with the activity to be derived in the ordinary course of business. This rule also applies if the real estate professional participated for more than 500 hours a year for any five of the previous ten years, whether consecutive or not.    

Real Estate Professional Test 

Taxpayers must satisfy three tests to gain the above benefits. To qualify as a real estate professional, a taxpayer must:  

1. Perform more than 50% of services in real property trades or businesses (“50% test”), 
2. Perform more than 750 hours of service in real property trades or businesses (“750 hours test”), and 
3. Materially participate in each rental activity (“material participation test”).  

Real Property Trade or Business Defined 

A real property trade or business is broadly defined under IRC Sec. 469(c)(7) to include real property development, re-development, construction, reconstruction, acquisition, rental, operation, management, leasing, or brokerage trade or business.1 According to Chief Counsel Advice 201504010, “real property trade or business” includes real estate brokers, but not mortgage brokers of financial instruments used to purchase real estate.  Similarly, the Tax Court has held that “mere financing of or investing in real property” was not a real property trade or business. 

The 50% and 750 Hours Tests 

For married taxpayers, the 50% test and 750 hours test must be met by one spouse alone. However, all real property trade or business activity is included under the 750 hours test, regardless of whether an election has been made to aggregate the properties into one real property trade or business, as discussed below. 

Material Participation Test 

Material participation is determined separately for each rental property. For taxpayers with several rental properties, it may be difficult to meet the material participation test on a separate property basis. Accordingly, the IRS permits taxpayers to make an election to treat all interests as a single rental real estate activity. The aggregation election is made by attaching a statement to a timely filed tax return. As a general rule, this election is binding until revoked and covers future years. Rev. Proc. 2011-34 provides relief for a late aggregation election if reasonable cause is established. 

Who Is Considered a “Material Participant”? 

Treas. Reg. Sec. 1.469-5T specifies that a taxpayer must satisfy at least one of the following to be considered a material participant:  

1. Work more than 500 hours in the activity (for purposes of material participation, IRC Sec. 469 specifies that participation of both spouses is counted; however, participation by children or employees is not counted); 
2. Do substantially all of the work in the activity; 
3. Work more than 100 hours in the activity and no one else works more than the taxpayer (including non-owners or employees); 
4. Total time in all significant participation activities (SPA), defined under Treas. Reg. Sec. 1.469-5T(c), exceeds 500 hours; 
5. Have materially participated in the activity in any five of the prior ten years; 
6. Materially participate in a personal service activity, defined under Treas. Reg. Sec. 1.469-5T(d), for any three prior years; or 
7. Participate in the activity on a regular, continuous, and substantial basis during such year based on the facts and circumstances. 

The material participation rules require an analysis of all surrounding facts and circumstances.  Generally, work performed as an investor is not treated as participation. However, when an individual is directly involved in the day-to-day management or operations of the real estate activity, the Tax Court has found that an otherwise investor-activity may count toward material participation.   

Contemporaneous Documentation 

To substantiate the time spent on real estate activities, the IRS requires detailed records to support the hours worked in real estate in relation to those worked in other businesses. The extent of an individual’s participation in an activity may be established by any “reasonable means.” Under Treas. Reg. Sec. 1.469-5T(f), reasonable means may include, but are not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing those services over that period, based on appointment books, calendars, or narrative summaries. The Tax Court found in the case Zaid Hakkak et ux., T.C. Memo 2020-46, that post-event "ballpark guesstimates" or unverified, undocumented testimony may be insufficient. 

Recent Real Estate Professional Cases 

With increased funding from the Inflation Reduction Act, the IRS has steadily increased its scrutiny of real estate professional status claims. Recent court decisions highlight the level of detail required to qualify as a real estate professional.   

In the 2023 case Drocella, et al. v Commissioner, a husband and wife owned and managed six rental real estate properties while also being full-time employees in other businesses. They maintained written logs with dates, times and work performed by each taxpayer for each property.  Another 2023 case, Foradis v. Commissioner, dealt with a taxpayer who was a full-time employee in a separate business who spent significant time constructing a “carriage house.” 

In both cases, the Tax Court found that the taxpayers failed to qualify as real estate professionals and could not deduct their rental real estate loss as they could not prove that they spent more than 50% of their total personal services time on real estate activities. Consequently, the taxpayers in both cases could not deduct any of their rental estate losses.  

In the 2022 case Dunn v. Commissioner, a husband and wife owned rental properties individually and through a real estate development LLC, while also holding full-time jobs as computer specialists. The real estate business hired outside consultants to collect rents, show apartments, and manage the property it held, with the taxpayers directly managing all other properties. The taxpayers kept two logs—one for the property held by the real estate LLC and one for the individually managed properties. They did not make an election to aggregate their rental real estate activities into a single activity.   

The Court determined that taxpayers failed to qualify as real estate professionals, finding that the logs provided were vague and misleading on time spent and who performed what tasks.  Due to their full-time jobs outside of real estate, the taxpayers were also unable to prove they met the 750 hours test or that their participation in their real estate activities was not less than their participation in other activities.   

In another 2022 Tax Court case, Sezonov v. Commissioner,  a husband and wife owned an HVAC business as well as rental properties. Mrs. Sezonov handled most of the day-to-day management of the rental properties, including advertising the properties, communicating with renters and prospective renters via email, and preparing the properties for rental. In addition to his full-time position in the HVAC business, Mr. Sezonov assisted in responding to emails and performed maintenance and repairs for the properties.  

At court, the taxpayers provided non-contemporaneous logs to support their time spent on the rental activities, with the hours spent estimated based on rental agreements and emails. The court found that the logs provided were unclear and did not show that Mrs. Sezonov met the 750 hours test for real estate professionals, nor did they establish that Mr. Sezonov spent more time in the real estate rental business than in his HVAC.  

Best Practices for Real Estate Professionals 

The ability to claim PAL deductions and avoid being subject to the NIIT can result in significant tax savings. Maintaining complete and accurate records that establish real estate professional status and material participation are essential. Taxpayers should also consider a timely aggregation election for multiple properties. Keeping contemporaneous records on hours worked in and outside of one’s real estate business and detailing the specific services performed in each activity is the best way to stay in compliance with these rules. While contemporaneous records are not required, the above cases demonstrate that taxpayers who prepare logs after the fact based on estimates often face difficulties with meeting the requirements.   

If you need help assessing whether or not you qualify as a real estate professional, EisnerAmper has a depth of resources to help our clients. Contact us today to find out how we can assist.  

In this issue:

• The IRS Contacted Me About Unpaid Taxes – Now What?
• Failure to File Forms 1099 Correctly Can Result in Hefty Penalties
• False Start: Why Newly Formed Online Businesses Should be Cautious When Deducting Business Expenses
• Are You a “Real Estate Professional?”