This is a continuation from a previous post from last week, “Real Estate Professionals For U.S. Federal Income Tax Purposes.”

What many taxpayers have a difficult time understanding is that qualifying as a real estate professional does not guarantee that your rental activities are non-passive. It simply means that your rental activity is not NECESSARILY passive regardless of your level of participation.

Qualifying as a real estate professional helps to prove that the taxpayer materially participates in their rental activities, and can treat them as non-passive for income tax purposes.

If in the above example, assume the following:

• The taxpayer spent 2,000 hours in the real estate trade or business as a construction manager as a day job
• The taxpayer happened to own one rental property in which only 50 hours was invested in the tax period working with a full time property manage,
• The taxpayer would still qualify as a real estate professional, by virtue of his 2,000 hours spent materially participating in his construction business.
• However, simply qualifying as a real estate professional is not enough to convert rental loss to non-passive status.
• To convert rental loss to non-passive status the taxpayer must also substantiate material participation in the rental activity.
• Having only invested 50 hours in rental property activity, and with consideration that other people (property managers) spent more time than him on the activity the taxpayer cannot establish material participation.
• As a result, even though the taxpayer is a real estate professional, rental losses remain passive and subject to the annualized loss limitation of $25,000.

These rules are a little mind numbing when you have only one rental property in the tax period. When multiple rental properties are involved, qualifying as a real estate professional becomes profoundly more complicated.

IRC Section 469 states that materially participating in the ONE activity requires 500 hours of the taxpayer’s time. But if you have ten rental properties or partnership interests for that matter you cannot reasonably expect to spend 500 hours in each activity. The regulations under Section 469 offer two alternatives for determining material participation when you have multiple activities.

Under Reg. Section 1.469-4, you can elect to group activities together for purposes of measuring material participation by electing to group your activities and subsequently collectively aggregate the total hours for the tax period invested in the grouped activities.

Taxpayers may group activities as they see fit, provided grouped activities represent an “appropriate economic unit.” This means that generally rental activities are not grouped together with non-rental activities.

Remember:

• Grouping together rental activitiescan be meaningless unless you qualify as a real estate professional.
• It doesn’t matter whether you materially participate, because all rental activities are treated as passive under Section 469.
• Qualifying as a real estate professional does not make your rental properties non-passive
• Qualifying as a Real Estate Professional creates the opportunity for the taxpayer to establish that they materially participate in their rental activities in which case their losses will be treated as NOT BEING PASSIVE.

Grouping Activities

Reg. Section 1.469-9(g) provides that for purposes of establishing material participation, a real estate professional may elect to treat all interests in rental activities as one activity.

In contrast to the Reg. Section 1.469-4 election addressed above, the Reg. Section 1.469-9 election is an “all or nothing” election in that requires the taxpayer to group all of the rental activities together, or not at all.

If the taxpayer makes the -9 grouping election, material participation in the rental activities is determined by summing the hours of time the taxpayer spent on all rental activities.

If the election is not assert, the taxpayer must establish material participation in each separate activity.

Regardless of the asserted election (“economic unit” or “all”) the taxpayer must:

1. Participate in a real property trade or business.
2. Materially participate in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T.
3. The time spent participating in real property trades or businesses must exceed the time spent on the “day job” and be greater than 750 hours in the tax year.

Tax Court Cases

In Jahina v. Commissioner, T.C. Summary Opinion 2002-150, a taxpayer was denied real estate professional status because she failed to make the election under -9 to aggregate all of her rental activities. As a result, the court concluded:

“As a consequence of the failure to elect, Mrs. Jahina must qualify as a real estate professional with respect to each property separately in order to avoid a determination that the rental activities were per se passive under Section 469.

Thus, to hold in petitioners’ favor, the Court must find

1) That more than one-half of Mrs. Jahina’s personal services during the tax year were performed in each rental property activity and,

2) that Mrs. Jahina performed more than 750 hours of services during the tax year on each of the claimed properties (emphasis added).”

In Jafapour v. Commissioner, T.C. Memo 2012-165 and Hassanipour v. Commissioner, T.C. Memo 2013-88 the Tax Court employed a similar approach.

In both cases the Tax Court is using the -9 election to determine if a taxpayer qualifies as a real estate professional.

The problem is that the regulations make clear that the -9 election becomes relevant only after a taxpayer has satisfied the two tests required to be a deemed Real Estate Professional, for the sole purpose of determining if the taxpayer materially participates in his rental activities.

Therefore, the court is asking the taxpayer who fails to file a grouping election to spend more than:

—half his/her time working on each rental activity, AND
—750 hours on each rental activity

This is not what the Code and regulations require, and placing this burden on a taxpayer can result in incorrect conclusions.

Example

If a taxpayer owns five commercial rental properties and invests time solely as follows:

• 600 hours on property A
• 300 hours on property B
• 300 hours on property C
• 250 hours on property D
• 300 hours on property E

Because the taxpayer does nothing else for the tax period under Reg. Section 1.469-5T the taxpayer materially participates in each property.

Even though the taxpayer materially participates in each separate activity, because there was no election to group the activities together under Reg. Section 1.469-9 when each property produces a loss for the year the taxpayer must measure his qualification as a real estate professional on a property by property basis.

Because the taxpayer did not spend more than 750 hours in any one property, he or she is not a real estate professional, and all of his losses will be treated as passive.

If the taxpayer grouped their properties:

1. The taxpayer meets the standard of participating in a real property trade or business as a leasing agent for the properties in question.
2. The taxpayer materially participates in that real property trade or business under one of the seven tests of Reg. Section 1.469-5T.
3. The time spent materially participating in real property trades or businesses exceed the time spent in the taxpayer’s ‘day job’ if you will as this is all the taxpayer does. And in excess of 750 hours was invested by the taxpayer materially participating in real property trade or business.

This should all be determined before addressing the implications of making the “all or nothing” grouping election of -9.

The taxpayer must materially participate in either the grouped rental activities—if an election was made under -9—or in each separate rental activity if no such election was made.

This is because the election -9 is only relevant when a taxpayer who has qualified as a real estate professional under the two quantitative tests of Section 469(c)(7) must take the next step of establishing that he materially participates in his rental activities.

In CCA 201427016, the IRS clarified that the “all or nothing” grouping election of Reg. Section 1.469-9 applies only after a taxpayer qualifies as a real estate professional.

The IRS concluded that the determination of whether a taxpayer satisfies the real estate professional rules is unaffected by the 1.469-9 grouping election and that the grouping election is relevant only after the taxpayer qualifies as a real estate professional to determine if the taxpayer materially participates in their rental activities.

Summary

Hopefully, you’ve learned that the “all or nothing” grouping election of Reg. Section 1.469-9 applies only after you determine if you are a real estate professional as well as the difference between being a real estate professional and material participation.