Many real estate professionals deal with the difficulties presented by the passive activity loss (PAL) rules. Regardless of how much time you spend working in your real estate activities, rental income or loss is generally considered passive and is subject to the passive activity loss rules (PAL). One of the most valuable exceptions to this rule is available to Qualifying Real Estate Professionals (QREP) who are involved in a “real property trade or business”. The principal advantages of QREP status is the ability to deduct real estate losses against other forms of ordinary income such as wages, along with the potential to reduce your tax obligation related to the 3.8% Medicare Surtax starting in 2013 (the “Surtax”).
To satisfy the QREP rules, the taxpayer must:
- Perform more than 50% of personal services for any tax year in real property trades or businesses in which he or she materially participates, and
- Perform more than 750 hours of service during the tax year in real property trades or businesses in which he or she materially participates.
Lastly, tax practitioners often overlook or misinterpret another condition in the Regulations which requires taxpayers to meet one of seven enumerated tests of material participation in the rental real estate activity, which is independent of the QREP requirements above. Other related conditions include:
- Work performed in the capacity as an investor generally doesn’t qualify. Qualified work normally means direct involvement in the day-to-day management or operations of the activity which typically means: advertising for tenants, speaking with potential tenants, showing properties to potential tenants, preparing leases for tenants, collecting rents, cleaning and maintaining units and common areas, receiving calls from tenants for repairs, paying bills, and maintaining books.
- Participation in a real property trade or business must be regular, continuous, and substantial. For example, work performed by lenders, appraisers, consultants, attorneys, and accountants on real estate related matters is considered incidental rather than a real property trade or business and therefore won’t qualify.
- Time spent by independent licensed real estate agents should count toward the QREP time requirements. The IRS had argued unsuccessfully that agents must be licensed brokers under state law in order to work in a qualified real property trade or business.
- Work performed as an employee will not count toward the 50% of personal services requirement nor the 750 hour requirement for QREP status unless the taxpayer also owns more than 5% of the employer.
- At least one spouse must separately satisfy both of the QREP time requirements when spouses file jointly. However both spouses can combine their time spent for the material participation test enumerated in the Regulations.
- Taxpayers with a second occupation unrelated to real estate should expect the IRS to challenge any QREP status, even if you work enough hours to otherwise qualify.
The chief peculiarity of these rules is that taxpayers must meet the QREP and material participation time requirements for each rental real estate interest owned; not likely with multiple properties. This problem often can be avoided by making an affirmative election on your tax return to aggregate all of your rental real estate ventures into a single activity (“Grouping Election”). Due to the complexity surrounding all these different rules, there are other important factors to be aware of:
- Rental real estate activities may not be grouped with other real estate activities such as development or construction in order to satisfy the material participation requirements. For example, a full-time real estate developer who also owns rental real estate generally would not be considered a material participant in his rental real estate activities if all of his time is spent in development activities, even if he qualifies for QREP status.
- If you own at least one of your rental real estate activities through a Limited Partnership (LP) interest, making the Grouping Election will expose all your rental real estate activities in the combined group to more stringent special tests of material participation. This can be avoided however if the amount of gross rental income from all your LP interests is less than 10% of gross rents from all rental real estate activities for the year. In addition, this rule may not apply to rental real estate interests owned through a Limited Liability Company (LLC), depending on your circumstances.
- Time spent in real estate management activities conducted through a separate legal entity will count towards determining material participation, but only to the extent it is in connection with property owned by the taxpayer.
- Taxpayers with suspended passive losses should be extra careful when considering whether to make the Grouping Election because the utilization of such losses in the future can be dramatically limited depending on your circumstances.
- Once the Grouping Election is made on an original tax return, it applies to all future years and generally cannot be revoked without IRS approval, unless there has been a material change in your facts and circumstances.
- Many taxpayers have failed to file this required statement, and subsequently have lost the QREP issue on an IRS exam.
- The IRS has granted relief through Revenue Procedure 2011-34, whereby taxpayers who meet certain conditions may file a late election by following the procedural requirements. The cost of a late election is likely far less than the cost of an IRS exam, back taxes, penalties, and interest.
- A rental real estate activity generally may not be grouped with an operating activity unless:
- The rental activity is insubstantial in relation to the operating activity (and vice versa), or the ownership of the rental and operational activities are the same, and
- The rental real estate activity and the operational activity constitute an “appropriate economic unit”, which is demonstrated by the following factors:
- Similarities and differences in the types of businesses,
- The extent of common control,
- The extent of common ownership,
- The geographical location, and
- Interdependencies between or among the activities.
- For example, a husband and wife (HW) jointly own ABC Management Company (ABC) and 25 rental real estate properties. ABC does not provide property management services to anyone else and is the sole provider of property management services to the HW properties. In this case, HW may group the ABC Management activity with their 25 rental real estate activities.
There can be significant downsides to making the Grouping Election because you are deemed to own a single activity in rental real estate. The principal drawback usually involves the sale of an individual real estate activity within the combined group, since this is not considered a disposition once the Grouping Election is made. Therefore, utilization of suspended passive activity losses in the future may become more problematic. As a result, if you have significant suspended passive losses and are considering a sale of property, it may be more beneficial to postpone making the Grouping Election until after the sale has closed.
Generally, the Grouping Election should only be made if it will allows you to satisfy the material participation requirement and some other tax benefit is realized, such as the deductibility of losses against other ordinary income. Because there are numerous pitfalls and traps associated with making the Grouping Election, taxpayers should exercise proper diligence and consult a tax advisor at Convergence that is an expert in this area.
Starting in 2013, the 3.8% Surtax may provide a large tax benefit and justification for making the Grouping Election. As we discuss here on our website, the Surtax targets income from passive sources, including rental real estate. The Surtax creates a new opening for real estate professionals to revisit their tax situation and consider revisions to an existing Grouping Election, or possibly making a new Grouping Election for the first time.
Furthermore, if you’re a real estate professional that is facing an IRS exam, you should expect the IRS to deny deductions for real estate losses if they exceed your income from such investments. The experts at Convergence have considerable experience assisting our clients with the documentation requirements necessary to successfully navigate through the many complexities surrounding this unique area of tax law.
Should you have any questions about this topic, or if we can improve your tax situation, please contact us. As a real estate consulting group, we’re more than willing to help you navigate the intricacies of real estate tax benefits available to QREPs.
IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (1) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (2) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
 A real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. This may include the purchase of goods or services, having the same customers or employees, or using the same set of books and records to account for the activities.