A Primer on Material Participation Rules for Real Estate Businesses. Part 4: Special Considerations for Real Estate Professionals with Rental Activities by Lacey Strachan
For taxpayers with rental properties, qualifying as a real estate professional under IRC Section 469(c)(7) is only the first obstacle in avoiding passive activity treatment for rental properties.
Definition of Rental Activity. As a threshold matter, it is important to determine whether an activity is in fact a rental activity for purposes of Section 469. A rental activity is defined generally as an activity where the gross income from the activity consists of amounts paid principally for the use of property held by the taxpayer in connection with the activity.[i] In addition to the real estate professional exception to the rule that rental activity is per se passive, there are also exceptions to what is considered a “rental activity.” If an activity is not considered a rental activity within the meaning of Section 469, the per se passive rule will not apply, allowing the Taxpayer to group the activity with other activities that constitute an appropriate economic unit, making it easier to satisfy the material participation test with respect to the activity. An activity will not be treated as a “rental activity” if:
- The average period of customer use for such property is seven days or less;
- The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owners of the property in connection with making the property available for use by customers (the nature of personal service provided is a facts and circumstances determination, with certain exceptions specified in Treasury Regulation Section 1.469-1T(e)(3)(iv)(B));
- Extraordinary personal services are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use). Examples provided include a hospital’s boarding facilities, where the rentals are incidental to their receipt of the personal services provided by the hospital’s staff, and the use by students of a schools’ dormitories is generally incidental to their receipt of the personal services provided by the school’s teaching staff.[ii]
- The rental of such property is treated as incidental to a non-rental activity of the taxpayer under paragraph (e)(3)(vi) of this section;[iii]
- The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers; or
- The provision of the property for use in any activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not rental activity under paragraph (e)(3)(vii).
Special Grouping Rules for Rental Real Estate. The general rule is that each rental property must be treated as a separate activity.[iv] However, real estate professionals have the option of grouping all of their rental properties together as a single activity under the regulations setting forth rules for certain rental real estate activities (Treasury Regulation Section 1.469-9).[v] For a taxpayer who has many rental properties, it may be difficult if not impossible for the taxpayer to satisfy the material participation tests with respect to each and every rental property, even if he works full time in the rental real estate business. The election allows taxpayers to treat their rental activities as a single activity, though taxpayers are still precluded from grouping their interests in rental property with other activities in the real estate industry or other activities that would create an appropriate economic unit.
While making the election could allow taxpayers with multiple rental properties to be able to deduct their losses on an annual basis, taxpayers must consider before making the election the potential consequences of such an election. In particular, if the taxpayer has suspended losses from rental activities despite grouping all of the real estate properties, the election presents a drawback for the taxpayer—if the taxpayer disposes of his interest in one of the rental properties that had a suspended loss, that loss will continue to be suspended until the taxpayer has disposed of all of his rental properties which he had elected to group together as a single activity.
Making an Election to Group Rental Activities. An election to treat all of a taxpayer’s interests in rental real estate as a single rental real estate activity can be made by the taxpayer in any year in which he is a qualified taxpayer (that is, meets the requirements to be considered a real estate professional under Section 469(c)(7)), and the election will be binding for the taxable year in which it is made and for all future years in which the taxpayer is a qualifying taxpayer, even if there are intervening years where the taxpayer does not qualify.[vi] The election may be made during any year in which the taxpayer is eligible.
The election is made by filing a statement with the taxpayer’s original income tax return for the taxable year that contains a declaration that the taxpayer is a qualifying taxpayer for the taxable year and is making the election pursuant to Section 469(c)(7)(A).[vii]
The election can be revoked only by a showing of a material change in the taxpayer’s facts and circumstances. To revoke an election, the taxpayer must file a statement with the taxpayer’s original income tax return for the year of revocation, containing a declaration that the taxpayer is revoking the election under Section 469(c)(7)(A) and an explanation of the nature of the material.[viii]
Satisfying One of the Material Participation Tests. Even if owners of rental real estate have elected to group their real estate activities as one activity, there are still challenges in satisfying the material participation tests. The taxpayer is limited to considering only the real estate professional’s hours spent on the rental activity and cannot consider the taxpayer’s other hours spent working for the taxpayer’s other real estate business(es). Moreover, the significant participation activity test—which taxpayers often rely on when they have multiple different activities that may not exceed 500 hours—is not available to taxpayers trying to satisfy the material participation test with respect to their interest in rental real estate. A significant participation activity is defined in pertinent part by reference to a “trade or business…other than rental activities…,” specifically excluding rental activities from qualifying for the significant participation activity material participation test.[ix] When applying the material participation tests to a rental activity, it is important to ensure that the material participation test being considered applies to the taxpayer’s facts and circumstances and takes into account only those hours spent participating in the rental activity.
[i] See Treas. Reg. § 1.469-1T(e)(3).
[ii] Treas. Reg. § 1.469-1T(e)(3)(v).
[iii] Requirements for this exception are set forth in Treas. Reg. § 1.469(e)(3)(vi).
[iv] Treas. Reg. § 1.469-9(e).
[v] Treas. Reg. § 1.469-9(g).
[vi] Treas. Reg. § 1.469-9(g)(1). The election will not apply in any year where the taxpayer is not a qualifying taxpayer.
[vii] Treas. Reg. § 1.469-9(g)(3).
[ix] See Treas. Reg. § 1.469-5T(c)(1)(i) (a significant participation activity is a trade or business activity “within the meaning of § 1.469-1T(e)(2)….”); § 1.469-1T(e)(2) (refers to § 1.469-1(e)(2)); § 1.469-1(e)(2) (“Trade or business activities are activities that constitute trade or business activities within the meaning of § 1.469-4(b)(1); § 1.469-4(b)(1) (“Trade or business activities are activities, other than rental activities….”).