An Overview of Passive Activity Rules: What Real Estate Investors Need to Know

There’s no question that real estate investing — and the tax implications that go along with it — can be an extremely complex business. Thanks to passive activity rules, income from rental real estate activities is considered passive by default. It’s important for investors to understand how these rules affect the way their income from their real estate portfolio is taxed.

There are carve-outs to passive activity rules, most notably the real estate professional status. Taxpayers who meet the criteria to qualify as a real estate professional can have their income (and importantly, their losses) from rental real estate activities be considered as non-passive. It’s a strategy that unlocks significant tax benefits.

In this overview, we’ll share a brief history of passive activity rules, explain how to determine whether you qualify for the real estate professional status, and discuss other strategies (like grouping elections) that can optimize your tax strategy.

Passive Activity Rules: A Brief History

Passive activity rules were first introduced as part of the Tax Reform Act of 1986. Before this reform, individuals with high incomes had been able to use real estate investments as tax shelters. They could use the losses from these investments (largely produced through depreciation) to offset their actively earned income.

The tax reforms effectively ended this practice, specifying that taxpayers could only deduct losses from passive activity against passive income. Any excess passive losses are suspended until future years when there is passive income or the activity is disposed of. The regulations also prescribed that all rental real estate issues would be treated as passive activities by default, effectively ending the previous tax shelter strategy used by many high-income individuals.

In 1993, a significant amendment — the Real Estate Professional Exception — was added to this law. This exception allowed qualifying taxpayers to have their rental real estate activities to be treated as non-passive, provided they fit certain criteria.

In 2014, the Frank Aragona Trust court case clarified that a trust can also be considered a real estate professional.

Real Estate Professional Status

If a taxpayer qualifies as a real estate professional, the income and losses from their rental real estate activities can be treated as non-passive and therefore used to offset actively earned income, such as that from a W-2 job or business ownership.

To qualify as a real estate professional, a taxpayer must satisfy two tests. The first is that they must spend more than 750 hours in a real property trade or business. A real property trade or business is generally construction, development, property management, brokerage, etc. It is not an indirectly linked business such as a real estate attorney.

The second test is that the individual must spend more than half of their time in a real estate business. This limitation is significant because, even if one spends more than 750 hours on a real estate business, they will not meet this threshold if they have another primary activity on which they spend more time.

Note that we say taxpayer, not individual. When a couple files their taxes under the Married Filing Jointly status, only one spouse has to qualify as a real estate professional. When one spouse is a high earner and the other is a real estate professional, the tax benefits of this strategy can be extremely advantageous.

Material Participation Tests

For any activity to be considered non-passive, a taxpayer has to pass the material participation test. Even if a taxpayer is classified as a real estate professional, they must still be materially participating with respect to the rental activities that they own.

There are seven tests that determine whether you are considered to have materially participated in the real estate activity, and taxpayers only have to pass one of them. In most instances, someone who qualifies as a real estate professional by managing their real estate portfolio will satisfy the first test (spending more than 500 hours on the activity during the year). This is considered the bright-line standard, although there are more nuanced situations where the other tests may apply.

1. 500-Hour Test: The taxpayer participated in the activity for more than 500 hours during the tax year.
2. Substantially All Test: The taxpayer’s participation constituted substantially all of the participation in the activity by all individuals during the tax year.
3. 100-Hour Test: The taxpayer participated for more than 100 hours during the tax year, and no other individual participated more than they did. If, for instance, a taxpayer had a handyman who spent 150 hours while they spent 120, they would not pass this test.
4. Significant Participation Activity Test: The activity is a significant participation activity, and the taxpayer’s aggregate participation in all SPAs exceeds 500 hours for the year.
5. 5-out-of-10 Year Test: The taxpayer materially participated in the activity for any five of the previous 10 tax years.
6. 3-Year Personal Service Activity Test: The activity is a personal service activity in which the taxpayer materially participated for any three preceding tax years.
7. Facts and Circumstances Test: Based on all facts and circumstances, the taxpayer participated in the activity on a regular, continuous and substantial basis during the year. This often applies to individuals who purchase a property in the last few months of the year and don’t have the time to meet the hour thresholds.

More detailed information on these material participation tests is available on the IRS website.

Certain activities, such as performing maintenance work or showing the property to prospective tenants, count toward these hours. Others, such as attending real estate seminars and researching properties, do not.

Documenting the time spent on activities is extremely important. If your status as a real estate tax professional or material participation is ever questioned by the IRS, having detailed, contemporaneous records of your participation in the real estate activities is key to successfully defending your tax position.

These tests can be complex, and we encourage you to connect with an experienced real estate tax advisor to determine if you qualify.

Grouping Elections

Grouping elections allows real estate professionals to consolidate all of their real estate activities into one activity for purposes of testing material participation. If you operate a large portfolio of rental properties, it’s unlikely you meet the material participation requirements on any one of those properties in isolation. But by grouping the activities, you can meet the tests in aggregate across all of your properties.

Grouping elections can also be strategized for taxpayers who fail to meet the qualifications to be a real estate professional but still have significant real estate holdings.

For example, you have an operating company and a holding company that leases real estate to the operating company. (This is typically done for liability purposes.) The holding company completes a cost segregation study on the asset, producing significant amounts of depreciation. By grouping the holding company and the operating company, the taxpayer can use the depreciation to offset the income of the operating company.

Net Investment Income Tax for Real Estate Professionals

The net investment income tax (NIIT) is a supplemental 3.8% tax that high-income taxpayers are subject to in addition to taxes on ordinary income or capital gains. Since income from rental real estate is considered passive income by default, income from these activities is typically subject to NIIT if the taxpayer’s income is above a certain threshold.

This can often come into play when a real estate investor disposes of an asset. Let’s say you sell a property and realize a $1 million gain. Ordinarily, this would be considered passive income, meaning you’d face a $38,000 NIIT tax bill. However, if you’re considered a materially participating real estate professional, you aren’t subject to NIIT because your income from real estate activities is not considered passive.

In short, qualifying as a real estate professional enables taxpayers to avoid NIIT, unlocking further tax savings in addition to those described. For a more comprehensive breakdown of NIIT, read Planning for NIIT (Net Investment Income Taxes).

Partner With James Moore on Your Real Estate Tax Strategy

While income and losses from rental real estate activities are considered passive by default, pursuing real estate professional status allows investors to overcome these passive activity rules. It’s a powerful tax strategy that can deliver significant savings for investors who materially participate in the management of their assets.

However, this is a complex area of the tax code and it’s crucial you have the right advice. Small mistakes in these areas, like not maintaining robust documentation or failing to check the right box on a tax return, can have major consequences.

At James Moore, our real estate tax professionals provide tax planning services to a wide range of professionals and investors in the real estate communities, from fund managers to private investors who qualify as real estate professionals.

If you believe you may qualify for real estate professional status, or need guidance around other real estate tax planning issues, contact a James Moore advisor now.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.