Can any owner of rental real estate qualify as a real estate professional?

Disclaimer: I am not an attorney or tax accountant.  This is a summary of information I have learned over the years.  You should consult a qualified professional for full information.

So in additional to your regular job/career (which have nothing to do with real estate), maybe you own an investment property or two.  Typically these investment properties will generate paper/tax losses when factoring in your initial down payments and depreciation.  It would be nice to deduct these paper losses against your other income for tax purposes. Unfortunately, under current tax law, losses from passive activities, which you do not “materially participate” (definition below), cannot be deducted against non-passive income (from your job or business which is your principle source of income).  Rental real estate activities are automatically treated as passive activities, even if the owner “materially participates” in the management, operations, leasing, etc.

One exception is that taxpayers can deduct up to $25,000 in losses and credits from passive real estate activities against non-passive income if they “actively participation” in those activities (active participation is a much lower bar than material participation).  The exception on the exception is that this does not apply to taxpayers with adjusted gross incomes over $100,000.

What’s “material participation” in an activity?
Material participation in an activity means involvement in the operations of the activity on a regular, continuous, and substantial basis. If a person passes one of the following seven tests, IRS accepts that as establishing material participation in an activity:

• participating in the activity for more than 500 hours in the tax year (the most frequently utilized test);
• participating in the activity if the taxpayer’s participation is substantially all of the participation in that activity by any individuals (including non-owners);
• participating in the activity for more than 100 hours in the tax year, if nobody else (including nonowners) participated more;
• participating significantly in the activity, if participation in all “significant participation” activities for the tax year exceeds 500 hours (but this test isn’t accepted for showing material participation in rental activities);
• having materially participated in the activity during any five of the ten tax years before the year at issue;
• with respect to personal service activities, having materially participated in the activity for any three years (not necessarily consecutive) before the year at issue;
• showing regular, continuous and substantial participation on the basis of all the relevant facts and circumstances, but only if more than 100 hours of participation during the tax year can be shown (and management services aren’t taken into account for purposes of this test unless certain stringent requirements are satisfied).

Why do I want to be a Real Estate Professional?
If you qualify as a “real estate professional,” your rental real estate activities are not automatically treated as passive.  Consequently, you will be entitled to deduct losses from that activity against non-passive income.  Additionally, the $25,000 deduction cap is removed to all you to deduct an unlimited amount against your non-passive income.

So how do you qualify as a Real Estate Professional?
Here is the summary details:

• You must materially participate in a real estate business (renting and leasing do qualify).
• More than 50% of the personal services you perform in all your businesses during the year must be performed in real estate businesses in which you material participate.
• Your personal services in a material participation real estate business must account to more than 750 hours per year.
• You must own at least 5% of the business that materially participates in the real estate business.  In other words, you can’t be the receptionist of large leasing company, work their 40 hours per week and claim material participation (as you don’t own 5% of the company doing that work).
• These tests are applied annually. This means that you may qualify as a real estate professional in some years but not in other years. As a result, the same real estate activity may generate passive losses in some years and non-passive losses in other years.

How do I prove Material Participation?
The extent of an individual’s material participation in an activity may be established by any reasonable means. But the most reliable means of showing material participation consists of keeping appointment books, calendars, daily time reports, logs, or similar documents that provide a detailed account of what yoy did with respect to an activity, when he or she did it, and how much time it took. Failure to document material participation is one of the most common ways of losing the right to treat rental real estate activities as non-passive (and to be in hot water during an IRS audit).

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