Real Estate Professional

From TaxAlmanac

Generally, rental activities are passive activities even if the taxpayer materially participated in them. However, if he/she is a real estate professional as set forth in IRC Sec. 469(c)(7)(B) Sec. 469. Passive activity losses and credits limited, rental real estate activities in which the taxpayer materially participated are not considered passive. For this purpose, each interest the taxpayer has in a rental real estate activity is treated as a separate activity unless he/she chooses to treat all interest in rental real estate activities as one activity. (See Schedule E instructions for more details).

Closely held corporations can also qualify as real estate professionals if more than 50% of the gross receipts for its tax year came from real property trade or business in which it materially participated. IRS Publication 925

To qualify as a real estate professional, the taxpayer must meet the following requirements:

1. More than half the personal services performed by the taxpayer in all trades and business were performed in real property trades in which he/she materially participated.

2. The taxpayer performed more than 750 hours of services during the tax year in real property trades.

Do not count personal services the taxpayer performed as an employee unless he/she was at least a 5% owner of the employer. If the taxpayer is filing a joint return, the spouse's personal services should not be counted. However, a spouse's participation can be counted for the purposes of meeting the material participation test.

A real property trade or business: develops, redevelops, constructs, reconstructs, acquires, converts, rents, leases, operates, manages, or brokers real property IRC Sec. 469(c)(7)(C) Sec. 469. Passive activity losses and credits limited and IRS Publication 925. Reg. 1.469-9(d) Treasury Regulations, Subchapter A, Sec. 1.469-9 provides tests to determine if a taxpayer’s business is considered being involved in real property trades or business. As a general rule taxpayers who only participate in trades or business that only involve real estate transactions are not considered to have materially participated in a real property trade or business. As an example an attorney or accountant who specializes in real estate would not be involved in a real property trade or business. The same holds true for someone involved in a real estate mortgage business. It seems that none of these individuals could treat rental losses as nonpassive even though most of their time involves real estate.

Remember even though most of the time having activities treated as nonpassive is to the taxpayer’s advantage, there are situations where leaving an activity as passive is a better strategy. An example is if the taxpayer’s rental activity is generating taxable income and it is believed it will do so for the coming years and the taxpayer has other activities that are passive and generating loss, it might be better for the taxpayer to leave the rental activity as passive and take advantage of the passive losses.

SELF-EMPLOYMENT INCOME

In general, when there is material participation (i.e., Real Estate Professional), rental income is self-employment income. (See below--This does not apply to certain farm rentals as described below in the excerpt from IRC section 1402(a)(1).)

Treating rental income as self-employment income will result in a tax savings in the early years of a rental when deductible expenses exceed revenue and a higher tax in the later years when rental income is positive. And there may be situations where income from a temporary rental may not be considered self-employment income.

IRC section 1402(a)(1): " . . .there shall be excluded rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer; except that the preceding provisions of this paragraph shall not apply to any income derived by the owner or tenant of land if (A) such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and (B) there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticulturalcommodity;" Janie 17:15, 31 Aug 2005 (CDT)