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NON-PASSIVE RENTAL LOSSES: NO FUN WITH DICK AND JANE

October 13, 2005

When normal people think of "passive activity," they probably think about sitting in the La-Z-Boy watching "Will and Grace" reruns. But tax people are different. We think of the tax law rules that deny net losses for business activities where "material participation" is lacking.

The passive activity rules provide that if you have net losses from "passive" business activities in a year, the net losses are disallowed. They instead carry forward until there is passive income, or until the "activity" is disposed of in a taxable transaction. Whether an activity is passive depends whether the taxpayers "materially participate" in an activity. While there are several tests to determine whether participation is "material," the most common test is 500 hours of participation.

When the passive activity rules were enacted in 1986, they contained a "per-se passive" rule for real estate rentals. Real estate rental losses were considered passive regardless of how much you worked at them.

In 1993 this "per-se" rule was loosened up for real estate professionals. These were defined as taxpayers who spent more than half their working time, and at least 750 hours, working in real estate. Taxpayers meeting this criteria can have non-passive losses from real estate rental, but only if they pass the normal "material participation" tests that apply to non-real estate businesses.

WHAT IS AN ACTIVITY?

Richard May, a civil service worker in Buffalo, New York, built up a nice side business of renting duplexes. By 1996 he had 18 duplexes. His tax preparer prepared is joint 1996 return for Richard and his wife, Jane. The return treated Richard as a materially-participating real estate professional, and the Mays deducted net rental losses of $73,247.

The IRS challenged the deductions, saying that each duplex was a separate activity, and that the taxpayer failed to meet either the 500 hour participation test or an alternative test of 100 or more hours each in multiple activities totalling 500 hours.

The taxpayer argued that they had taken advantage of a provision of the passive loss rules (Sec. 469(c)(7)(A)) allowing them to treat multiple activities as a single activity. He said they met this requirement by reporting the multiple activities as a single activity on his 1040.

The Tax Court disagreed:

On the basis of the record, it is not clear from any of petitioners' relevant returns that petitioner made an election under section 469(c)(7)(A). Petitioners' consistent treatment of aggregating the rental income and expenses on their Schedules E is not a deemed election to treat the rental real estate activities as a single activity under the requirements of section 469(c)(7)(A). Accordingly, petitioner did not elect to treat his rental real estate activities as a single activity under section 469(c)(7)(A).

THE MORAL: ALWAYS USE THE MAGIC WORDS. If you are a real estate pro, and you want to deduct your rental losses from multiple rental units, it's not just enough to group your rental units as a single schedule E activity. You also need to say the magic words - not "please, may I," but "I elect to aggregate my rental activities pursuant to Sec. 467(c)(7)(A)." Once made, the election is good for future years.

Cite: May v. Commissioner, T.C. Summary Opinion 2005-146.

The extended entry below reviews the basics of the "material participation" rules.

MATERIAL PARTICIPATION BASICS

The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

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