I am glad to
see that the IRS has reversed course on an issue concerning real estate
professionals.
You may
remember that “passive losses” entered the tax Code in 1986 as retaliation
against tax shelters. The IRS had previously battled tax shelters using challenges
such as “at-risk,” but 1986 brought a new and updated weapon to the IRS armory.
The idea is
simple: separate business activities into two buckets: one bucket for material
participation and a second for passive. The classic material participation is
an activity where one works more than 500 hours. Activities in the material participation
bucket can offset each other; that is, losses can offset income.
Move on to
the second bucket. Losses can offset income – but not beyond zero. The best one
can do (with exceptions, of course) is get to zero. One cannot create a net
loss to offset against net income from bucket one.
Consider
that tax shelters were placed into bucket two and you understand how Congress
changed the tax Code to pull the rug out from under the classic tax shelter.
It was
quickly realized that the basic passive activity rules were unfair to people
who made their living in real estate. For example, take a real estate developer
who keeps a few self-constructed office condominiums as rentals. If one went
granular separating the activities, then the real estate development would be a
material participation activity but the condominium rentals would be a passive
activity. This result does not make sense, as all the income in our example originated
from the same “activity.”
So Congress
came in with Section 469(c)(7):
469(c)(7) SPECIAL RULES FOR
TAXPAYERS IN REAL PROPERTY BUSINESS.—
469(c)(7)(A)
IN GENERAL.— If this paragraph applies to any taxpayer for a taxable
year—
469(c)(7)(A)(i) paragraph (2) shall not apply to any rental real estate
activity of such taxpayer for such taxable year, and
469(c)(7)(A)(ii) this section shall be applied as if each interest of the
taxpayer in rental real estate were a separate activity.
Notwithstanding clause (ii), a taxpayer
may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be
construed as affecting the determination of whether the taxpayer materially
participates with respect to any interest in a limited partnership as a limited
partner.
469(c)(7)(B)
TAXPAYERS TO WHOM PARAGRAPH APPLIES.— This paragraph shall apply
to a taxpayer for a taxable year if—
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
469(c)(7)(B)(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.
Look at
Section 469(c)(7)(B)(ii) and the reference to 750 hours. There was confusion on
what happened to the plain-vanilla 500-hour rule. Was a real estate pro to be held
to a higher standard?
Here for
example is the Court in Bahas:
Mrs. Bahas misconstrues section 469. Because petitioners did
not elect to aggregate their real estate rental activities, pursuant to Section
469(c)(7)(A) petitioners must treat each of these interests in the real estate
as if it were a separate activity. Thus,
Mrs. Bahas is required to establish that she worked for more than 750 hours each
year with respect to each of the three rental properties.”
How in the
world did we get from 500 hours to 750 hours for each of Mrs. Bahas’ activities?
This is not what Section 469(c)(7)
appears to say. There was a torrent of professional and academic criticism on Bahas
and related decisions, but in the interim practitioners (me included) elected
to aggregate all the real estate activities into one activity. Why? To make
sure that one got to the 750 hours, that is why.
Academicians
could argue the sequence of phrases and the intent of the law. Practitioners had
to prepare annual tax returns, protect their clients and wait their time.
And now it
is time.
The IRS released
ILM 201427016 to discuss how the “750-hour test” works when one has multiple
real estate activities. It includes the following obscuration:
However, some court opinions, while reaching the correct
result, contain language which may be read to suggest that the election under Treas.
Reg. 1.469-9(g) affects the determination of whether a taxpayer is a qualified
taxpayer.”
The IRS
finally acknowledged that the 750-hour rule is not a substitute or override for
the generic 500-hours-to-materially-participate rule. A real estate taxpayer goes
activity-by-activity to determine if he/she is materially participating in each
activity. If it is advantageous, the taxpayer can also make an election to
aggregate all real estate activities before determining material participation
status.
Then, once all
that is done, the IRS will look at whether the taxpayer meets the more-than-half
and more-than-750-hours tests to determine whether the taxpayer is a real
estate pro.
There are
two separate tests. One is to determine material participation and a second to
determine real estate pro status.
A bit late for
Mrs. Bahas, though.
No comments:
Post a Comment