Passive Activity loss limitations for Real Estate business - Part 1
July 28, 2004
By Jim Harnsberger, Sr. Tax Analyst

SAN DIEGO – The question of whether real estate investment activity is a “passive” activity or a “business” is guided by facts and circumstances; and a very detailed analysis of the Internal Revenue Code. Generally one has a limit on the amount of “loss” that is allowed as a deduction for real estate related activity. (e.g. residential rental property as an example) However, if the activity involves “active” and “material” participation, the loss deductions allowed under the code are $25,000 per year. More significant is the fact that if the activity is characterized as a “business” activity; then all losses without limits are allowed as deductions against all other ordinary income.

Where do we begin in understanding this question and the complex rules necessary to apply the code in making the determination? The best place of course is with the Code.\Rental activities generally are treated as passive activities without regard to the extent that the taxpayer materially participates in the activity. Sec. 469(c)(2).

Rental activities involving real estate are not necessarily passive activities if the taxpayer is a qualifying taxpayer under section 469(c)(7). See sec. 1.469-9(e)(1), Income Tax Regs. Instead, the rental real estate activity of a qualifying taxpayer who materially participates in the activity is not subject to the passive activity rules of section 469. Sec. 469(c)(7); sec. 1.469-9(e)(1), Income Tax Regs.

A taxpayer is considered to materially participate in a trade or business if his activities are regular, continuous, and substantial. Sec. 469(h)(1).

In establishing whether a taxpayer's real property activities result in passive activity losses, each interest in rental real estate is treated as a separate rental real estate activity unless the qualifying taxpayer makes an election to treat all interests in rental real estate as a single rental real estate activity. Sec. 469(c)(7)(A); sec. 1.469-9(e)(1), Income Tax Regs. See Madler v. Commissioner , T.C. Memo. 1998-112; S. Rept. 99-313, 737-738 (1986), 1986-3 C.B. (Vol. 3) 1, 737-738.

The active participation standard can be met as long as the taxpayer participates in a significant and bona fide sense in making management decisions or arranging for others to provide services such as repairs. Madler v. Commissioner , supra .

A qualifying taxpayer must meet the following requirements under section 469(c)(7)(B):

(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.
Part 2 in this series will explore the standards required to meet these tests along with exceptions to the general rule.

San Diego based Tax Smart America provides a unique method to properly account for, plan, and take advantage of the tax code in order to meet the tests imposed under the code, and to meet the requirements classifying real estate activities as “active” or in some cases as a “business”.
For more information visit their website at www.taxsmartamerica.biz or contact the company at (619) 469-5800.