Passive Activity Losses & Real Estate Professionals
Caveat emptor: Watch out real estate professionals—don’t assume losses from all your rental properties are automatically nonpassive.
Some would think that using losses from one activity to offset income from another activity would be a relatively easy strategy to help mitigate their income taxes, especially if they’re a real estate professional. Not so fast, say the courts!
Recent court cases have highlighted the fact that the rules treating rental real estate activities of a qualifying real estate professional as nonpassive are complex and often misunderstood. An all-too-common mistake is assuming that qualifying as a real estate professional automatically allows taxpayers to treat their activities as nonpassive.
In Eger v. United States, the taxpayers owned 33 rental properties, including three resort properties, which were the properties at issue in this case. The taxpayers treated all their properties as a single rental activity by claiming an election under Internal Revenue Code Section 469(c)(7). The District Court accepted the stipulated facts that the taxpayers met the requirements to claim status as real estate professionals and made the relevant election(s) under the code.
In general, taxpayers in the real property business or real estate professionals can exclude their rental activity or activities from the passive activity loss rules. Thus, at first glance, it appears the taxpayers took every necessary step to help ensure they could treat the real estate activities as nonpassive activities. So, why would the IRS and later the District Court reverse the taxpayers’ position? The devil is in the details, as not all real property activities are deemed to be rental activities under the code and regulations.
What constitutes a passive activity or rental activity? The answer: It depends. Not only are the definitions under the code and regulations at issue, but also the structure of each management agreement.
Under the general rules of Reg. §1.469-1T:
A “passive activity”1 is defined as a trade or business activity in which the taxpayer doesn’t materially participate for such taxable year, or a “rental activity,” without regard to whether or to what extent the taxpayer participates in such activity.
A “rental activity”2 is defined as tangible property held in connection with the activity used by customers or held for use by customers, and the income attributable to the activity represents amounts paid or to be paid principally for the use of such tangible property.
The regulation also sets forth seven exceptions to the definition of “rental activity.” The central tenet at issue was one of the exceptions, which states that the activity is not a rental activity if “[t]he average period of customer use for such property is seven days or less.” 3 A “period of customer use” is further defined as “[e]ach period during which a customer has a continuous or recurring right to use [the property].”4
The court found that the management companies couldn’t be considered the end-users under each of the management agreements; as the management companies didn’t retain a “continuous or recurring right to use the properties,” they were unable to exert “possession, dominion and control” over the properties and they weren’t provided the exclusive access to rent the properties, either individually or to third parties.5
As a result, the court found the taxpayers’ argument that the management company should be considered the end-user failed, and, therefore, the IRS’ argument—that each resort property isn’t a “rental activity” since the average period of customer use was seven days or less—has merit.
Ultimately, the taxpayers were prohibited from grouping the three resort properties with their 30 other rental activities under §469(c)(7) as a result of the average period of customer use exception. And, presumably, without the election, the taxpayers didn’t materially participate in each of the resort activities.
As one can see, the argument that each rental property qualifies as a rental activity under the code and regulations is a fact-sensitive issue, and the facts and circumstances regarding each property must be evaluated. This is often a time-intensive exercise but is a worthwhile endeavor, as the IRS and courts have shown that noncompliance can be costly.
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1 Reg. §1.469-1T(e)(1)(i-ii) ↩
2 Reg. §1.469-1T(e)(3)(i)(A-B) ↩
3 Reg. §1.469-1T(e)(3)(ii)(A) ↩ 4 Reg. §1.469–(e)(3)(iii)(D) ↩
4 White v. C.I.R. T.C. Summary Opp. 2004-139, 2004 ↩
5 Hairston V. C.I.R. T.C. Memo 2000-386, 2000 ↩