Understanding the Real Estate Professional Exception to the Passive Activity Loss Rules

The 1986 Tax Reform Act introduced the concept of passive activity loss (PAL) limitations.  Prior to the PAL rules, taxpayers could invest in businesses in which they did not work and deduct tax losses against their earnings and investment income.  While the passive activity rules generally restrict the deduction of PALs to passive activity income, certain exceptions apply.  A passive activity includes any rental activity.  It also includes any business in which an individual does not materially participate.  Material participation in a business can be met under one of seven tests set forth in tax regulations.  The general standard is that an owner must work at least 500 hours during a year in the business in order to deduct a loss against nonpassive income.

As a general rule, losses from rental real estate activities are always passive.  A special rule, known as the "real estate professional" exception, permits real estate losses to be reclassified as nonpassive.  Nonpassive losses are deductible against any category of income.  However, the requirements for meeting the real estate professional exception are often misunderstood.  Each real estate rental property is considered to be a separate activity unless an election is made to group the properties as a single activity.  This grouping election is an important factor in meeting the requirements of the real estate professional exception.

A real estate professional must first meet a two-prong test.  Then the individual must materially participate in his or her real estate rental activities.  The two-prong test requires that an individual spend more than 50% of his or her working time in "real property trades or businesses" in which the individual materially participates, and that the amount of this time exceeds 750 hours during the year.  Time worked as an employee does not count unless the individual owns more than 5% of the company with whom he or she is employed.  Real property trades or businesses include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.  The misunderstanding is that meeting these two prongs is enough to change passive real estate rental losses into a nonpassive losses.

After qualifying as a "real estate professional," the individual must also materially participate in each real estate rental activity.  Material participation will be impossible if the taxpayer does not elect to group separate real estate rental activities into one activity, because it isn't possible to work 500 hours or more in each separate activity when several properties are involved.  The grouping election is made in the income tax return and is effective for future tax years.  In the event of an audit, the IRS insists that detailed time logs be produced to prove that both the two-prong test and the material participation test are met.