Rental activities are generally classified as passive activities. If the rental activities result in net passive loss for the year, then a taxpayer is generally restricted from deducting the net loss. The losses are suspended and released in the future, when a taxpayer has passive income or disposes of the activity. In addition, if the rental activities result in net passive income for the year, then the net income may be subject to the 3.8% net investment income tax.
Rental real estate activities of certain real estate professionals are not treated as passive if certain requirements are met. Accordingly, net losses from rental activities would be fully deductible in the year realized, while net income from the rental activities would not be subject to the 3.8% net investment tax.
There are two general tests that must be met to qualify as a real estate professional. These tests are applied annually:
- More than 50% of personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, AND
- The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.
A taxpayer may aggregate rental activities together to meet the above test.
Real Property Trades or Businesses:
The Regulations define a real property trade or business to include: real property development, redevelopment, construction, reconstruction, acquisition, rental, operation management, leasing or brokerage.
Personal Service Performed:
To substantiate that a taxpayer qualifies as a real estate professional, a taxpayer should maintain documentation of the time spent between regularly paid activities and time spent on real property trade or business activities. In determining the time spent on real estate activities, a taxpayer need not perform the work directly. Time spent also includes services such as supervising, planning, investigating, attending meetings, etc. Following are examples of time qualifying as time spent on a real property trade or business:
- Physically performing the development, redevelopment, construction, and reconstruction work
- Planning including, meeting with sales people planning officials; architects; engineers; construction personnel; drafters; accountants; attorneys; and other providers
- Supervising including, reviewing plans; supervising personnel; reviewing engineering prints
- Acting as the property manager including, meetings with contractors and tenants
- Acting as a rental agent including, advertising; showing properties; screening tenants; negotiating leases; and establishing lease criteria
- Acquiring properties including, investigating; viewing and negotiating properties to acquire
- Selling properties including, showing properties; negotiating; meeting with brokers, agents, and prospective buyers
- Arranging for financing including, meeting with lending personnel and accountants
- Reviewing insurance contracts and meeting with insurance agents
- Reviewing and approving invoices or paying invoices related to the property.
It is important to note that service hours performed in the capacity of an investor are generally not regarded as time spent on a real property trade or business and accordingly do not qualify. This includes:
- Studying and reviewing financial statements
- Studying and reviewing reports on operations
- Preparing or compiling summaries or analyses of the finances