Under the passive loss rules, rental activities are automatically classified as passive. However, several years ago Congress carved out a special exception to these rules as they apply to real property rentals and made the exception available only to real estate professionals. The Two-Prong Test

Under IRC Sec. 469(c)(7), qualifying real estate professionals, such as brokers and developers, may treat rental real estate activities in which they materially participate as nonpassive. Thus, they are able to use losses and credits from such activities to offset nonpassive income, including wages, interest, and dividends. An individual is treated as a real estate professional for a particular tax year if the following requirements are met:

more than 50% of the taxpayer’s personal services and more than 750 hours of the taxpayer’s services

are performed in real property trades or businesses in which the taxpayer materially participates. Notice that material participation is a necessary condition to satisfying either portion of this test. In addition, once a taxpayer qualifies as a real estate professional, nonpassive treatment is available only for rental real estate activities in which the taxpayer materially participates [Reg. 1.469-9(e)(1)]. In other words, a taxpayer must pass two material participation hurdles before a rental real estate activity receives nonpassive treatment. [Material participation for both purposes is determined under the same seven-part standard of Temp Reg. 1.469-5T(a) that otherwise applies for purposes of the passive loss rules.] Thus, determining whether a taxpayer is eligible for the real estate professional’s relief from the passive loss rules is a two-step process. The taxpayer must:

qualify as a real estate professional (i.e., meet the 50% of personal service test and the 750-hour text) and materially participate in the rental real estate activity for which relief is sought. [In determining whether a taxpayer materially participates in an activity, each interest in rental real estate is normally treated as a separate rental real estate activity. However, taxpayers may elect to aggregate rental real estate activities to meet this material participation test—see Reg.1.469-9(g).]

Married Couples

For a husband and wife, the 50% and 750—hour tests are satisfied if one spouse individually satisfies the tests. However, for the purpose of determining material participation, one spouse’s participation counts as participation for the other spouse [IRC Sec. 469(h)(5); Reg. 1.469-9©(4)]. Thus, a husband and wife are eligible to take advantage of the special rule for real estate professionals if, during the tax year, either spouse materially participates in the rental real estate activity, and one spouse performs more than 50% of his or her personal services and more than 750 hours in real estate trades or businesses. This rule applies regardless of whether the spouses file a joint return [Reg. 1.469-9(c)(4)].

Real Property Trades or Businesses

The term real property trade or business means real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. This generally includes real estate builders, contractors, and property managers, as well as owners of rentals and real estate brokers/agents. A facts and circumstances test is applied to determine a taxpayer’s real property trades and businesses and any reasonable method may be used in applying the facts and circumstances [Reg. 1.469-9(d)].

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