2014-Issue 27—The passive activity loss rules of Section 469 of the Internal Revenue Code limit the losses that an individual, trust, estate, closely held C corporation, or a personal service corporation can recognize from trade or business activities in which the taxpayer does not “materially participate.” Congress enacted the Section 469 passive activity loss rules in 1986 as part of its response to the tax shelter investments of the 1970s and early 1980s, which allowed some taxpayers to generate large passive tax losses that offset their taxable income from other sources.
Now, the Internal Revenue Service is showing a renewed focus on the passive activity loss rules in Section 469, and in particular on the exception to these rules for real estate professionals. The most immediate cause of this focus is the new tax on net investment income. The net investment income tax in Section 1411 imposes an additional 3.8 percent tax on a taxpayer’s net investment income in excess of certain thresholds. Section 1411 and the related regulations cross-reference the passive activity rules in Section 469 to identify certain income subject to this new, additional tax.
However, the application of Section 469 within Section 1411 is not the only reason the passive activity loss rules are in the spotlight. A&M’s recent experience, and anecdotes that we have heard in the marketplace, indicate that the IRS has become more aggressive in policing more traditional Section 469 issues. Finally, the Tax Court also recently held in favor of the taxpayer in a case concerning Section 469, Aragona Trust v. Commissioner, 142 T.C. No. 9 (March 27, 2014). Aragona Trust held for the first time that a trust can qualify as a real estate professional and that the trust’s rental real estate activities are not subject to the Section 469 passive activity loss rules. Given this renewed interest in Section 469, it is important to review how the passive activity loss rules apply to real estate professionals.
Section 469 generally prevents individuals, trusts, estates, closely held C corporations, and personal service corporations from using current losses from passive business activities to offset income from salaries, active business activities, or portfolio investment income. Instead, Section 469 generally suspends passive activity losses until a taxpayer has future passive activity income or ultimately disposes of the passive activity investment.
Although Congress aimed the passive activity loss rules at tax shelter investments, the rules as originally enacted in 1986 posed a significant challenge for all rental real estate investors. The problem was that Section 469(c)(2) defines passive activity to include any rental activity. It is quite common for rental real estate investments to generate tax losses, even if the investment generates a positive cash flow. Thus many rental real estate investors found that their tax losses from these investments were suspended by Section 469, as originally enacted.
The real estate industry responded to this problem quickly, and in 1993 Congress amended Section 469 to exclude certain rental income of real estate professionals from the passive activity loss rules. Specifically, this real estate professional exception allowed certain taxpayers to treat rental real estate investments as active businesses, and use losses from those investments to offset other taxable income.
For the two decades following 1993, the real estate professional exception was significant primarily for individuals with rental real estate investments that were generating tax losses. Recently, however, we have seen several trends that both reduce the amount of losses for which real estate professional status provides a benefit and increase the number of taxpayers to whom this status is relevant.
In recent audits, the IRS has challenged how a real estate professional evaluates losses from rental real estate investments held in partnerships. The Schedule K-1 that real estate investors receive from a partnership separately reports ordinary business losses and net rental real estate losses. Certain taxpayers who qualify as real estate professionals have taken the position that all of the partnership’s activities represent an appropriate economic unit for purposes of Section 469, and thus neither the ordinary business losses nor the net rental real estate losses from a real estate partnership were subject to the passive loss limitations.
However, A&M’s experience, supported by anecdotes we have heard in the marketplace, is that the IRS has asserted in recent audits that certain real estate professionals must treat ordinary business losses and rental real estate losses from the same partnership as two separate activities, and that a taxpayer’s real estate professional status is relevant only to the net rental real estate losses. Depending on a taxpayer’s specific facts and circumstances, these arguments may force the taxpayer to suspend the ordinary business loss from its partnership investment under the passive activity loss rules, notwithstanding the taxpayer’s status as a real estate professional. Thus, this IRS position has the potential to decrease the amount of losses to which a real estate professional status is relevant.
Although the IRS may be trying to limit the amount of losses to which the real estate professional status is relevant, two recent developments have meant that more taxpayers may benefit from this status. The first development is the 3.8 percent net investment income tax that applies to income from passive activities beginning in 2013. As discussed below, real estate professional status is a way to exclude rental real estate from Section 469. Consequently, this status can allow taxable income from rental real estate to avoid the 3.8 percent net investment income tax, if certain other requirements are also met.
The second development that increases the number of taxpayers who may be interested in real estate professional status is the Aragona Trust case. Historically, the IRS has taken the position that only individuals may qualify for real estate professional status. The Aragona Trust case held for the first time that a trust can also qualify as a real estate professional under the right circumstances.
In light of these recent developments, it is important for all real estate investors to review the requirements to achieve real estate professional status, to understand how real estate professional status interacts with the net investment income tax rules, and to understand the limits of the Aragona Trust decision.
Qualifying for Real Estate Professional Status
Section 469(a) and (b) provide that any net loss that an individual, estate, trust, closely held C corporation, or personal service corporation recognizes from “passive activities” during a taxable year is disallowed and carried to the next taxable year. Section 469(c)(1) defines a passive activity as the conduct of any trade or business in which the taxpayer does not materially participate. The Internal Revenue Code defines material participation in Section 469(h) to mean “regular, continuous, and substantial” involvement in an activity’s operations. Section 469(c)(2) and (c)(4) say that, unless the taxpayer qualifies as a real estate professional, passive activity includes any rental activity — even where the taxpayer materially participates in the rental activity.
Under Section 469(c)(7)(B), a taxpayer qualifies as a real estate professional if:
- More than one-half of the personal services performed in trades or businesses during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and
- The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Real property trades or businesses are not limited to rental real estate. They also include real property development, construction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Significantly, for activities that a taxpayer undertakes as an employee to count toward the 750-hour threshold in Section 469(c)(7)(B)(ii), the taxpayer must own at least five percent of his or her employer.
Even if a taxpayer qualifies as a real estate professional, Section 469 suspends the taxpayer’s losses unless he or she also materially participates in the activity that gave rise to the loss. The Code provides some relief, however, because Section 469(c)(7) allows a taxpayer to elect to treat all rental real estate activities as one activity for purposes of Section 469. Treasury Regulations Section 1.469-5T(a) provides detailed rules to determine whether an individual taxpayer has materially participated in an activity; these rules focus on the number of hours that an individual spent participating in various activities. Treasury Regulations Section 1.469-5T(g) states that the regulations for material participation by trusts and estates have been reserved.
Interaction of Section 469 and the Net Investment Income Tax
Section 1411(c)(2) provides that the net investment income tax applies to a trade or business that is “a passive activity (within the meaning of Section 469) with respect to the taxpayer.” Thus, the net investment income tax does not apply to income from a trade or business within the meaning of Section 162 that is not a passive activity for the taxpayer. Real estate professional status is relevant to the net investment income tax in two ways. First, a taxpayer that can qualify as a real estate professional can avoid the net investment income tax by proving that:
- The rental real estate activity is a trade or business within the meaning of Section 162; and
- The taxpayer materially participates in that business.
See Preamble to T.D. 9644 (Nov. 26, 2013); Instructions to Form 8960 (2013).
Second, Treasury Regulations Section 1.1411-4(g)(7) provides a safe harbor for a real estate professional that participates in a rental real estate activity either for more than 500 hours during a tax year or more than 500 hours during any five of the 10 preceding tax years. The definition of real estate professional in Treasury Regulations Section 1.1411-4(g)(7) specifically cross-references the definition of real estate professional in Section 469.
Thus, under Section 1411 and the related regulations, real estate professional status may now provide a significant tax advantage for taxpayers with rental real estate investments that consistently generate taxable income.
Implications of Aragona Trust
The Aragona Trust case held that a trust qualified as a real estate professional based on the activities of its trustees. Aragona Trustconsidered a complex residuary trust that conducted rental real estate and other real estate activities directly and through various subsidiaries. Three of the trust’s six trustees worked full-time in a wholly owned subsidiary of the trust that managed most of the trust’s rental real-estate properties. On its income tax returns, the trust treated all of its rental real estate activities as non-passive, and used losses from these activities to offset other trust income.
The IRS claimed that the Aragona Trust did not qualify as a real estate professional for two reasons:
- Only an individual could qualify for this status; and
- The Aragona Trust did not materially participate in real property trades or businesses.
The Tax Court rejected both of these arguments. First, the Tax Court held that real estate professional status is not limited to individuals, and that a trust could qualify for this status. The Tax Court also rejected the IRS’s argument that the Aragona Trust did not materially participate in the trust’s real property businesses. The Tax Court held that all of the time that trustees who were also employees of the trust’s wholly owned management company spent working on the trust’s real estate operations should be attributed to the trust when determining whether the trust materially participated in those activities. Finally, the Tax Court also held that when the time that trustees spent as employees is also considered, it was clear that the trust materially participated in its real estate activities.
Aragona Trust is significant for holding that a trust can qualify as a real estate professional, and that a trustee’s time spent working as an employee of the trust should be considered when determining whether the trust itself materially participated in a real estate activity.Aragona Trust is equally significant for the issues that it did not address. In particular, Aragona Trust does not provide any guidance about how to determine whether a trust meets the requirements in Section 469(c)(7)(B) that the trust perform more than 750 hours of services during the year on real property businesses and spend more than half its personal services on real estate businesses.
The court specifically noted that the IRS did not assert this argument and thus, within the arguments raised in the Aragona Trust case, the trust qualified as a real estate professional. Finally, the Aragona Trust opinion also does not address all of the potential ramifications of the trust’s business activities on its status as a trust. Instead, the Aragona Trust opinion notes in footnote 11 that the IRS did not argue that the trust’s business activities should cause the trust to be treated as a business trust that is taxed as a corporation under Treasury Regulations Section 301.7701-4(b). See Aragona Trust, 142 T.C. No. 9.
With the caveat that it did not address arguments that the IRS did not assert, Aragona Trust held that the trust’s rental real estate activities were not passive activities within the meaning of Section 469.
Alvarez & Marsal Taxand Says:
In general, the renewed IRS focus on Section 469 should remind taxpayers of the importance of maintaining contemporaneous documentation of the time that they spend in various business activities. Aragona Trust reminds us that, although the passive activity rules in general and material participation in particular are fact-intensive analyses, a taxpayer with the right facts and supporting documentation can still prevail.
More specifically, the new developments and renewed interest from the IRS in the application of the Section 469 passive activity loss rules pose both opportunities and threats for real estate professionals. For individuals who can qualify, making the election to have real estate professional status is something that they should consider and discuss with their tax advisors. The opportunity to benefit from this status for investments that generate either taxable income or taxable losses means that real estate professional status can provide a benefit to more real estate investors.
Additionally, taxpayers that invest in real estate through partnerships should pay close attention to how partnerships report their activities. In particular, taxpayers should ensure that a partnership reports income and expenses on the appropriate sections of the form. Given the IRS’s focus on the difference between a partnership’s ordinary losses and its rental real estate losses, the manner in which a partnership reports an item can have a significant effect on an investor’s tax liability.
Finally, taxpayers should be careful regarding the conclusions they draw from Aragona Trust. The Tax Court opinion in Aragona Trustdoes not address how a trust measures whether it spends half its personal services on real estate activities or whether the trust has spent at least 750 hours on real estate activities. Satisfying the taxpayer’s burden of proof for these measurements could be complex if the IRS were to assert this argument in a future challenge to a trust. In addition, a footnote in Aragona Trust acknowledges the possibility that, if a trust has sufficient business activities, the trust could be treated as a business trust that is taxed as a corporation.
Under Treasury Regulations Section 301.7701-4(b), a business trust may be treated as a corporation or a partnership for federal income tax purposes. Obviously, trusts that conduct business operations should be careful to avoid being treated as corporations for federal income tax purposes. If the IRS were successful in arguing that a trust’s business activities should be taxable as a corporation, there would be two levels of tax on those business activities: one level of tax at the trust and a second level of tax on the beneficiaries. The cost if a trust were to be taxed as a corporation would more than offset any benefit from avoiding the net investment income tax.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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