Last week the IRS issued Chief Counsel Advice 201427016 clarifying that taxpayers may aggregate their time spent in connection with rental activities to determine whether the taxpayer qualifies as a “real estate professional” for purposes of the passive activity loss limitation rules, regardless of whether the taxpayer elects to treat all of his rental activities as a single activity. A copy of that CCA can be found here. This CCA contradicts the position we have seen the IRS take in recent audits. In those audits, the IRS agent disallowed non-passive activity losses associated with the taxpayer’s rental properties on the grounds that that a taxpayer could not meet the 750-hour requirement to qualify as a real estate professional if the taxpayer did not elect to treat all of his or her rental activities as a single activity. The IRS’s acknowledgment of this pro-taxpayer (not to mention correct) position will assist many taxpayers with rental properties who intend to deduct their losses as non-passive activity losses. The IRS is finally getting this right.
Section 469 of the Internal Revenue Code limits deductions for passive activity losses. Distinguishing non-passive and passive activities has become more important following the recent enactment of section 1411, which imposes an additional 3.8% tax on certain income from passive activities. The distinction between passive and active activities is also more important in the tax enforcement context, as we have seen a recent rise of audits involving non-passive activity losses. The Code defines passive activities as activities “in which the taxpayer does not materially participate.” I.R.C. 469(c)(1). The IRS has issued regulations outlining seven tests to determine material participation. If the taxpayer meets any of those seven tests, the taxpayer is deemed to have materially participated in the activity and the taxpayer’s losses from that activity are not limited by section 469. For example, a taxpayer who spends more than 500 hours doing work associated with an activity is deemed to materially participate in the activity.
Taxpayers involved in rental activities who claim their losses are not passive have faced greater scrutiny from the IRS because rental activities are per se passive under section 469(c)(2). However, if a taxpayer can demonstrate that he or she is a real estate professional, the rental activities are not per se passive, but are subject to the material participation tests outlined in the regulations. To qualify as a real estate professional, a taxpayer must spend more than 750 hours working in real property trade or businesses in which he or she materially participates and more than one-half of the personal services he or she performed during the year must be performed in connection with the real property trade or businesses.
The challenge for many taxpayers is demonstrating that they qualify as a real estate professional. The IRS previously argued that prior Tax Court cases suggested that each rental activity must independently meet the requirements for a real estate professional unless the taxpayer elects to aggregate his or her rental activities on the return. The IRS has also taken that position in the audits in which we represent the taxpayer. This position is wrong. The Chief Counsel Advice clarifies that an election is not relevant for determining whether the taxpayer is a real estate professional. This will make it easier for taxpayers to prove that they are real estate professionals. Once the taxpayer qualifies as a real estate professional, he or she must satisfy the material participation test for each rental activity to make the activity non-passive, unless the taxpayer uses grouping elections to create one or more “grouped” activities (as appropriate).