Somerset Real Estate Team News

By Robert Klein, CPA

With the end of 2010, real estate professionals should review the special rules that entitle them to deduct losses from rental real estate activities at once rather than carrying them forward to future years. In general, all rental real estate activities are passive, so losses incurred by non-professionals can only be deducted against passive income. Passive losses exceeding passive income for the year must be carried over to future years.

Exception for Real Estate Professionals

For real estate professionals, rental real estate losses are currently deductible if (1) during the year if more than 50 percent of their personal services are performed in real properties businesses, and (2) more than 750 hours are spent in real property businesses.

For both tests, a taxpayer must “materially” participate in the real property businesses. If a joint return is filed, one spouse must meet both tests. Services performed as an employee are ignored unless the employee owns more than five percent of the employer-firm. A closely-held C corporation that is generally subject for the passive loss rules will satisfy these tests if more than 50 percent of its gross receipts are derived from real property businesses in which the corporation materially participates. Real property businesses are those involving real property development, redevelopment, construction, acquisition, conversion, rental operations, management, leasing and brokerage (but not lending).

Proving Material Participation

The IRS has seven tests for determining “material participation.” The following is a brief statement of each test, with an indication of the type of records that should be kept by the taxpayer:

1. The 500-hour test. An individual materially participates in an activity by spending more than 500 hours on it during the year. Since this requires ten hours per week on average, an individual is not likely to meet the test unless the activity is his primary source of income. A diary, contemporaneous daily time reports, logs or similar documents showing the exact hours of participation should be kept.
2. The substantially participation test. An individual materially participates in an activity if the involvement represents substantially all the involvement as compared to anyone else. This test is intended for persons who run sideline or seasonal businesses. Because a comparative test is involved, the taxpayer must maintain records covering all those involved in the activity, including owners, employees and independent contractors.
3. More-than-100-hours test. Material participation exists when (a) an individual spends more than 100 hours in the activity during the year and (b) the participation is at least as much as the participation of any individual. This is a variation of the preceding test, and the same documentation rules apply.
4. Significant participation activities test. This test applies to an individual involved in several activities. If the individual (a) participates for more than 100 hours in each of the activities and (b) the total participation in all the activities is more than 500 hours, the individual will have materially participated in all of them. Detailed time records should be maintained, since failure to establish participation in any one activity may result in all being treated as passive activities.
5. The 5-out-of-10-years test. The test applies primarily to persons who have retired from an active real estate trade or business but still maintain an ownership interest. The rule seeks to prevent a person from treating retirement income as passive income that can be sheltered by passive losses. Also, the rule says that if the person had materially participated in the activity in any five out of the ten previous tax years, current income will be active income and not be passive loss.
6. Personal service activity test. This test has the same purpose as the 5-out-of-10-years test, but applies to persons who have retired from a personal service activity, such as architecture, accounting, law, engineering or any other business in which capital is not a material income producing factor. If the person materially participated in it for any three taxable years, whether or not consecutive preceding the current year, then the person’s current income or loss from the activity is active and not passive.
7. Facts and circumstances test. An individual can establish material participation by showing facts and circumstances that he or she participated on a “regular, continuous and substantial basis,” at a minimum of more than 100 hours. This means that daily time records must be maintained. In addition, management services cannot be included in the needed 100 hours, unless the person spent more time in managerial activities than any other person.

OBSERVATION: Material participation for a limited partner’s interest can be achieved only under tests 1, 5 or 6. This is because an interest as a limited partner in a partnership is treated as a passive activity without regard to material participation in the statue, except for the tests indicated above.