Determining your level of involvement is key to the tax treatment of the income/losses that the real estate generates. Real estate, by definition, is a passive investment, but depending on your level of participation you may be able to treat the rental as active or be classified as a “real estate professional” for tax purposes. This allows you to deduct losses the activity generates, or avoid the net investment income tax if the activity generates income. Certain actions and tests are necessary to be eligible.
First, in any arena, you must meet the material participant requirement from a business activity to make it nonpassive. There are seven ways to do that, any of which can be used by the IRS to determine whether you’ve materially participated.
Tests for Material Participation (7 tests, you need to meet 1)
To materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis (IRC Sec. 469(h)(1)).
Individuals can meet the participation requirements by satisfying one of seven tests determined by the IRS. The tests that measure this according to Temp. Reg. Sec. 1.469-5T(a)(1) are:
The first three are the ones the majority of real estate investors qualify for.
Indicators that the taxpayer did not materially participate (Straight from the IRS Technical Audit Guide)
It’s now a great time to remind you of our simple litmus test to keep you out of trouble: if the day-to-day operations of your real property trade or business and your rentals would be unaffected by the hours you are claiming on your time log, then those logged hours don’t count.
You must materially participate in each passive activity (each rental property) separately
The taxpayer must materially participate in each passive activity separately. This means if you own 5 rentals, you must show you materially participated in each individual rental activity which can be extremely difficult to do. To get around this, you can make a grouping election under IRS Regs. Sec. 1.469-9(g) but it is highly recommended you speak to a CPA prior to this as the election can have negative long-term consequences.
To get around this issue, we can group all rental activities into one. We then just need to demonstrate material participation in the aggregate.
The grouping election is found in Regs. Sec. 1.469-9 and requires a formal election statement to be attached to your tax return in the year of making the election. This will group all rentals into one activity for purposes of Section 469. The election is binding for all future years and all future years rental activities are automatically added to the group.
Proceed with caution though. This grouping election can create problems if you have suspended passive losses. When you sell a property in a group of properties, you may not have disposed of “substantially all” of the activity which will limit your ability to claim losses upon sale.
Do the material participation requirements change if I’m an LP?
If the taxpayer holds an interest in a real property trade or business through a limited partnership interest, the taxpayer may establish material participation only by satisfying the first, fifth, or sixth tests of the seven tests from above.
This article is provided for illustrative purposes only; it does not provide personalized tax, legal, financial, or other professional advice. Your situation may be different; consult a professional for information concerning your individual tax, financial, or legal situation before taking any action.