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Why I think the Tax Court judge got the passive loss 750-hour test wrong

August 28, 2010

Last week I questioned whether a Tax Court judge was correct when he commented that absent an election to combine rental real estate activities under Sec. 469(c)(7), each real estate activity has to meet the "750 hour test" to make a taxpayer a "real estate professional." This often would make a taxpayer's status as passive or non-passive hinge on a procedural foot-fault -- the filing of the Sec. 469(c)(7) election.

If a taxpayer becomes such a "qualified taxpayer," then rental real-estate losses can be non-passive, and therefore deductible even absent offsetting "passive" income.

An alert reader poses this question to me:

Re the 750 hour test, Reg.§ 1.469-9(e)(1) appears to support the judge's conclusion.

Excerpt from reg:

"... Each interest in rental real estate of a qualifying taxpayer will be treated as a separate rental real estate activity, unless the taxpayer makes an election under paragraph (g) of this section to treat all interests in rental real estate as a single rental real estate activity. Each separate rental real estate activity, or the single combined rental real estate activity if the taxpayer makes an election under paragraph (g), will be an activity of the taxpayer for all purposes of section 469 ..."

Your thoughts?

Well, they're long -- Jim Maule long -- so if you are interested in this sort of thing, read on.

Here's my thinking. The 750 hour requirement is one of two requirements for "qualifying taxpayers" in Sec. 469(c)(7)(B), as follows (my emphasis):

(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

The Code language here clearly allows for time of multiple "trades or businesses" to be combined in reaching the 750-hour threshold. Nothing here seems to treat rental real estate activities differently for this purpose.

It matters because for most purposes of the code, you can "materially participate" with fewer than 750 hours in an activity. For non real-estate activities, for example, 500 hours gets you to material participation. If you combine two 500-hour activities, that should get you over the 750-hour hump. That is, it will unless the 750-hour test not only defines "qualifying taxpayer," but also "material participation" with respect only to rental real estate "trades or businesses."

So how is "material participation defined" for this purpose? Remember, Code Sec. 469(c)(7)(B)'s 750-hour test only determines whether you are a "qualifying taxpayer." Nothing defines "material participation" differently for this purpose in the statute. The Code does require that each "interest...in rental real estate" be treated as a separate activity absent the aggregation election, but it doesn't specify that the material participation requirements for those "activities" are any different than for non-real estate activities.

Do the regulations answer our question? The regulation for the special real estate rule, Sec. 1.469-9, defines "material participation" this way: "Material participation has the same meaning as under §1.469-5T. " In other words, the same way as for any other activity. The reg nowhere incorporates the 750-hour test into the "material participation" rules.

As the qualifying taxpayer test refers explicitly to "trades or businesses" in plural form, clearly you can combine different ones to get to the 750 hours. Nothing in the code or regulations carves rental activities from this treatment.

So:

-You get to be a "qualifying taxpayer" for the real estate test by clearing the 750-hour and more-than-half-your-time tests, and

-No definition of material participation incorporates the 750-hour test.

Given that, I see no basis for the judge's statement that the 750-hour/half-your-time tests have to be met for each rental real estate activity when there is no aggregation election.

So while I agree that the judge in the case reached the right conclusion, given that the taxpayers admitted they didn't reach the 750-hour threshold no matter what, I don't understand why he made that statement about the aggregation election. It wasn't necessary for his result, and I don't find where it is supported by the law. I really wish he hadn't said it, as I can easily see it leading to IRS mischief.

Tags: passive activities.passive losses.

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