Industry Insights

Before the Tax Reform Act of 1986, taxpayers could generally invest in partnerships or similar vehicles, generating deductions and credits useful for offsetting income from wages, interest, dividends and other sources. After the act, the income (or loss) from these activities was considered “passive,” unless the taxpayer “materially participated” in the activity. The act also restricted use of losses from a passive activity against non-passive income. 

Taxpayers’ participation is material only if they meet one of seven tests. The primary test is based on participation; if you are involved in an activity for more than 500 hours annually, the activity generally won’t be treated as passive.

By definition, real estate rental is deemed a passive activity. In 1993, the real estate industry was given special status in determining participation status in rental real estate investments. Most taxpayers are required to determine, on an activity-by-activity basis, whether they meet the material participation standard. “Real estate professionals,” however, are treated differently.

An individual is a “real estate professional” if:

1. More than half of the personal services the taxpayer performs during that year are performed in real property trades or businesses in which the taxpayer materially participates, and
2. The taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which he or she materially participates.

To more easily meet the second part of this test, real estate professionals can treat all of their rental interests as a single rental real estate activity.

Ordinarily, this election needs to be made on an individual’s “timely filed” return. The IRS historically has been reluctant to grant relief for taxpayers on late elections to group their real estate activities. Those who hadn’t made timely elections needed to obtain a private letter ruling from the IRS to grant relief or needed to meet the material participation rules on a separate property-by-property basis.

The IRS, however, has just issued these individuals relief; under Revenue Procedure 2011-34, published in May 2011, qualified individuals may make this election by attaching a statement to an amended return for their most recent tax year. The amended return must contain the required information, explain the reason for failure to file a timely election and be made under penalties of perjury.

Taxpayers are qualified individuals if they meet the follwing criteria:

1. Failed to make an election to aggregate their activities solely because they failed to timely meet the election requirements
2. Filed all historical returns consistently with having made an election
3. Timely filed each return that would have been affected by the election had it been timely made
4. Have reasonable cause for its failure to meet the requirements in the regulations

Reasonable cause would cover the situation in which “the taxpayer believed that it had previously made the required election and has recently determined that the election was not in fact included in a previously-filed income tax return.”

The IRS estimates only 2,000 taxpayers will need to seek relief under Rev. Proc. 2011-34 and may be underestimating the extent of this issue. Taxpayers seeking relief should immediately contact their BKD advisor to determine if they qualify and how best to proceed.