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Michael Redemske

Real Estate Professionals Find a PAL

In Tax Court as well as the IRS.

June 9, 2011
by Michael Redemske, CPA

You cannot deduct losses from passive activities to offset non-passive income, such as wages, interest and dividends generally. To the extent total deductions from passive activities exceed total income from those activities, the excess — called the passive activity loss (PAL) — is not allowed as a current deduction. Instead, the PAL is suspended and carried forward until you generate passive activity income or until you dispose off the entire interest in the passive activity in a taxable transaction.

A passive activity involves conducting a trade or business in which you do not participate materially. By definition, any rental activity is a passive activity, regardless of whether you participate materially. However, there are special rules for real estate rental activities and real estate professionals.

Material Participation

Temporary regulations issued in 1988 provide seven tests for determining whether you participate materially in an activity:

  • You participate in the activity for more than 500 hours during the year.
  • Your participation constitutes substantially all of the participation in the activity of all individuals, including non-owners.
  • You participate in the activity for more than 100 hours during the year and your participation exceeds any other individual’s participation during the year.
  • You participate in “significant participation activities” for an aggregate of more than 500 hours during the year.
  • You participated materially in any five years during the preceding 10 tax years.
  • You participated materially in any three preceding years, if the activity is a personal service activity.
  • You participated on a regular, continuous and substantial basis during the year, taking into account all the relevant facts and circumstances.

If you hold your interest in the activity as a limited partner, only tests one, five or six may be used to meet the material participation requirement.

LLC Members

The Internal Revenue Service (IRS) has lost a series of cases in which it argued that members of a limited liability company (LLC) should be treated in the same manner as a limited partner when applying the PAL rules.

The IRS tested this theory in Newell v. Commissioner, TC Memo 2010–23. Both the IRS and Newell agreed that the fourth test was the significant test in the case. They also agreed that an activity is a “significant participation activity” only if:

  • The activity is a trade or business;
  • The individual participates in the activity more than 100 hours during the year; and
  • The individual cannot establish material participation under any of the other six tests.

The IRS agreed that Newell met the test as described; however, that test is not available to limited partners. And the IRS argued that members of LLCs should be treated as limited partners.

The Tax Court rejected the IRS’s argument in Newell just as it had in Garnett v Commissioner, 132 TC No. 19. The U.S. Court of Federal Claims reached a similar conclusion in Thompson v. United States, 87 Fed. Cl. 728.

The IRS has acquiesced to the result in Thompson and has indicated that it will stop litigating these cases pending the issuance of new guidance.

Rental Activities

As a general rule, a rental activity is treated as a passive activity. But special rules apply to rental real estate activities in which you or your spouse participate actively. Under this exception, your maximum PAL deduction is limited to $25,000 per year. This maximum is reduced by 50 percent of the amount by which your adjusted gross income (AGI) exceeds $100,000. So, if your AGI is greater than $150,000, no deduction is available under this exception.

Real Estate Professionals

A different exception applies to certain real estate professionals. If you meet this test, you can treat your real estate activities as non-passive. To qualify as a real estate professional:

  • More than one-half of the personal services you perform in all your business activities during the year must involve real property trades or businesses in which you materially participate; and
  • You must perform more than 750 hours of service during the year in those real property trades or businesses.

In James. F. Moss et. ux. v. Commissioner, 135 T.C. No. 18, the Tax Court concluded that being “on call” was not the same as participation. James Moss was a full-time employee at a nuclear power plant. He also owned and managed four rental properties.

Moss produced a calendar and accompanying analysis showing that he spent a total of 645.5 hours during the year working on his rental properties. Moss contended that he met the 750-hour test because he was “on call” for at least another 100 hours during the year. He noted that any time he was not working at the nuclear power plant, he could have been summoned to one of his rental properties.

The Court concluded that the 750-hour test requires actual service in the activity, not merely a readiness or availability to participate in the activity.

Earlier this year, the Tax Court refused to believe Yusufu Anyika, who contended that he worked full-time as an engineer and also spent more than 1,800 hours per year doing maintenance, repairs and renovations to his real estate properties. Anyika v. Commissioner, TC Memo 2011–69.

Even though daily time reports, logs or similar documents are not required to support your active participation, you should expect the IRS to challenge your claim as a real estate professional, particularly if you have another full-time job.

Aggregation Election

If you own more than one real estate activity, you must qualify each one separately under the two-pronged test for real estate professionals, unless you make an election timely and properly to treat all your interests in real estate as a single activity. For most real estate professionals, the election is advantageous.

Normally, the election is due with a timely-filed tax return. So if you overlook the election, you must meet the test individually for each activity. In Revenue Procedure 2011–34, the IRS has provided guidance that allows a late election in limited circumstances. You are eligible to make the late election if all of the following apply:

  • You failed to make the election solely because you failed to timely meet the requirements specified in the regulations.
  • You filed your returns as if you had made the election for all years including and following the year you intend the election to be effective.
  • You timely filed each return that would have been affected by the election.
  • You had reasonable cause for failing to make the election.

If you are not eligible to make a late election under the revenue procedure, you may request relief by applying for a private letter ruling and paying the required user fee.

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Michael R. Redemske, CPA, is an instructor in residence at the University of Connecticut where he teaches federal income taxes and personal financial planning.