Does your client qualify as a real estate professional?

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Author: Woodford, John R.

The 1993 Budget Reconciliation Act contained a provision that excludes certain rental real estate activities of real estate professionals from the passive activity rules. You may be surprised to find that you do not have to be a full-time real estate agent to qualify.

Sec. 469(c)(7)(B) defines real estate professionals as taxpayers who perform more than one-half of their personal services in real estate trades or businesses in which they materially participate and the time spent is at least 750 hours. Only real estate trades or businesses in which the taxpayer materially participate are aggregated for determining hours worked.

On a joint return, only one spouse need qualify, but that spouse must meet the requirements separately. Hours of service performed as an employee count if the taxpayer owns a 5 percent or more interest in the employer. The exclusion also applies to a closely held C Corporation if more than 50 percent of its gross receipts are from real estate trades or businesses in which it materially participates.

The definition of real estate trades or businesses is broader than that used under the regular passive activity loss rules. It includes any interest in rental real estate, even those giving rise to Sec. 212 deductions.

Personal services are defined as any work performed by the taxpayer in connection with a trade or business. Services performed in the capacity of an investor are excluded. Investor types of services are described as: studying and reviewing financial statements or reports on operations of the activity; preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use; and monitoring the finances or operations of the activity in a non-managerial capacity.

Only those in which the taxpayer materially participates qualify for exclusion. Material participation for this purpose has the same meaning as it does under the general passive activity rules. Each interest in rental real estate is considered a separate activity in this determination.

An election can be made to treat all rental real estate activities as one activity. If made, all rental activities will be aggregate for purposes of determining material participation and exclusion. It will also aggregate these activities for all purposes of Sec. 469, including former passive activity rules and dispositions. The election is made on an original return and is binding for year of election and all future years, even if there are intervening years in which the taxpayer does not qualify.

The election can be revoked, but only in a year when the taxpayer's fact and circumstance are materially changed from the year in which the election was made. Regulations indicate that simply being disadvantageous to the taxpayer to have the election is not reason enough to revoke the election in effect, nor is no longer qualifying.

The hours of service performed by the taxpayer's spouse in the activity are added to the taxpayer's hours of service to determine material participation. This applies even if the spouse does not have an interest in the activity, or they do not file joint tax returns.

In determining hours of service performed in an activity, rental real-estate activities cannot be grouped with any other activity. Regulations give an example of a qualifying taxpayer who develops real property, constructs buildings, and owns an interest in rental real estate; only the participation in the rental real-estate activity is used in determining material participation. An exception would be involvement in the activity of management of rental real estate; the hours spent in managing property the taxpayer owns is included in determining material participation.

If the taxpayer owns a rental real-estate activity through a limited partnership interest, care should be taken in making the election to combine all rental real-estate activities. Under 1.469-9(f), if an election to combine is in effect and one of the rental real estate activities is a limited partnership interest, then the combined group of activities will be considered a limited partnership interest, subjecting them to the more restrictive material participation rules under 1.469-5T(e)(2).

For any taxable year that a qualifying taxpayer materially participates in a rental real-estate activity, that activity will be treated as a former passive activity under Sec. 469 if disallowed deductions or credits are allocated to the activity under 1.469-1(f)(4). Thus any suspended losses allocated to the activity will be subject to the passive activity rules.

It is up to the taxpayer to substantiate his or her position. The regulations state that 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 are not required if the extent of such participation may be established by other reasonable means. Reasonable means includes, but is not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries. While the regulation seems to give the taxpayer large leeway, there is no substitute for good record keeping. Tax practitioners should encourage the keeping of diaries documenting services performed in rental real-estate activities, if their clients want to claim exclusion under the Section 469 rules.

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By John R. Woodford, CPA

John R. Woodford is a partner with Robertson, Woodford & Francis in Grass Valley.