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A Primer on Material Participation Rules for Real Estate Businesses, Part 2: Who is a Real Estate Professional? by Lacey Strachan

Taxpayers in Real Property Business. Although the general rule is that all rental activities are by definition passive, the Code has created an exception for certain professionals in the real estate business.  A real estate professional (as that term is defined under Section 469(c)(7), the section that sets forth the exception to the rule that all rental activities are per se passive) is defined as a taxpayer who (1) spends more than 750 hours in the tax year working in a real property trade or businesses in which he materially participates and (2) performs more than one-half of his personal services during the tax year for real property trades or businesses.[i]

Definition of a real property trade or business. A “real property trade or business” is defined to include “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”[ii]  Although this list is quite comprehensive, it is important to note that the definition of a real property business does not explicitly include real estate financing.  In a recently issued Tax Court Summary Opinion, Hickam v. Commissioner (TC Summary Opinion 2017-66, August 17, 2017)[iii], the Tax Court held that a taxpayer who brokered real estate mortgages and originated residential and commercial loans was not a real estate professional within the meaning of Section 469(c)(7), because the taxpayer’s mortgage brokerage and loan origination businesses were not real property trade or business as defined in Section 469(c)(7)(C).  The Tax Court concluded that although the loans he brokered and originated were secured by real property, his mortgage brokerage services and his loan origination services did not involve operating the real properties that secured those loans—although he had a “brokerage” trade or business, it was not a “real property brokerage.”

Qualifying as a Real Estate Professional. In determining whether a taxpayer qualifies as a real estate professional, the only hours that count towards the real estate professional test are those in which the taxpayer has an interest and materially participates.  Services performed for a real estate business as an employee generally do not count for qualifying as a real estate professional, unless the taxpayer is at least a 5% owner of the employer.  In the case of taxpayers filing a joint return, spouses may not combine their hours to satisfy these requirements.[iv]  This differs from the rules applicable to satisfying the material participation rules, which allow spouses to combine hours worked.

If a taxpayer qualifies as a real estate professional, he avoids the per se passive rule for rental activities.  However, he will still have to satisfy the material participation tests (subject to additional limitations applicable to rental activities), in order to establish that the rental activity is a non-passive activity for purposes of Section 469.  These obstacles include prohibiting rental activities from being grouped with other real estate-related undertakings in applying the material participation tests, and prohibit a taxpayer from grouping his rental real estate activities together as a single activity, unless the taxpayer affirmatively makes an election to do so.

[i] IRC § 469(c)(7)(B).

[ii] IRC § 469(c)(7)(C).

[iii] Hickam v. Commissioner, Docket No. 3901-16S (TC Summary Opinion 2017-66, August 17, 2017), available here: https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11368.

[iv] However, note that in satisfying the material participation test for purposes of determining whether an activity is a passive activity, hours contributed by the spouse may be included in the number of hours of participation by the taxpayer in the activity.

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