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Passive Activity Loss ATG - Chapter 2, Rental Losses

Publication Date - December, 2004

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


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Chapter 2, Rental Losses

In A Nutshell

Rentals generally are passive activities and are subject to the passive loss disallowance rules. See IRC § 469(c)(2). A loss from a passive activity is not currently deductible unless one of the following applies:

  • Passive income exists (losses are allowed to the extent of passive income);
  • The taxpayer actively participates in a rental real estate activity and qualifies for the $25,000 special allowance;
  • There is a qualifying disposition under IRC § 469(g); or,
  • The taxpayer meets the requirements of IRC § 469(c)(7) for real estate professionals.

Audit issues, exclusions, and exceptions are discussed later in this chapter. For Rental Income issues, see Chapter 3.

Issues

  • The $25,000 rental real estate allowance under IRC § 469(i)(8) allows individuals to offset losses from rental real estate without necessarily having passive income.
  • Six exceptions exist to the definition of “rental” (Reg. § 1.469-1T(e)(3)(ii)). Certain activities normally thought of as “rentals” are specifically treated as non-rental businesses under this section.
  • A real estate professional is permitted treat a rental activity like any other business, i.e. the taxpayer must materially participate to treat it as non-passive.
  • Equipment rentals normally are passive whether or not the taxpayer materially participates and do not come under the rules for active participation or material participation. Because equipment leases do not involve rental real estate, they are not able to use even the special $25,000 offset under IRC § 469(i).[1]
  • Short-term vacation rentals are often treated as businesses, subject to the material participation standard.   

The $25,000 Allowance In a Nutshell

A taxpayer may deduct up to $25,000 in rental real estate losses as long as the taxpayer actively participates and MAGI is less than $100,000. 

Exception:  the amount allowed for married taxpayers filing separately is either $12,500 (if they did not live together) or zero (if they did live together during the year).  See active participation checksheet at end of chapter.

Sub-Issues

  • The activity must consist of rental real estate (not an equipment lease).
  • The taxpayer must have “actively participated” in the rental.
  • The MAGI must be less than $100,000 in order to obtain the full $25,000 benefit.

Issue Identification

  • The Form 8582, Part II, will show the amount of the special allowance that was calculated by the taxpayer.
  • Look for rental or non-rental losses deducted without completing Form 8582 including those generated by partnership and S- Corporations.   

Active Participation Sub-Issue

As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity.  There is no specific hour requirement.  However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager.

Several categories of taxpayers do not meet the standard of active participation and therefore do not qualify for the $25,000 special allowance:

  • A limited partner in an activity (IRC § 469(i)(6)(c)).
  • A taxpayer who has less than 10 percent ownership (IRC § 469(I)(6)(A)).
  • A trust or corporation.  The $25,000 is available only to natural persons. 

Exception:  Grantor trust owned by a natural person because it is not deemed a separate entity.

  • A taxpayer whose rental activity consists of a net lease. Under a net lease, the tenant pays most of the expenses.

Examination Techniques: 

  • Review Schedule K-1s to determine whether the taxpayer is a limited partner or a general partner.
  • Review ownership interests in each activity to determine whether the taxpayer meets the 10 percent ownership requirement. 

Modified Adjusted Gross Income Sub-Issue

The full $25,000 allowance is available for taxpayers whose MAGI is less than $100,000.  For every $2 a taxpayer’s MAGI exceeds $100,000, the allowance is reduced by $1. 

Example:  If MAGI = $110,000, the $25,000 allowance is reduced by $5,000 to a $20,000 maximum allowance.  Once MAGI exceeds $150,000, the special allowance is no longer available. 

Exception:  commercial revitalization deduction.

Examination Techniques:

  • Look for taxpayers who are not real estate professionals (no entry on Schedule E line 43), but deducted rental real estate losses in excess of $25,000.
  • Watch for returns with an AGI over $150,000 and rental losses were deducted.  If the taxpayer is not a real estate professional, the $25,000 offset is usually not available.  In the absence of passive income or a disposition, losses are not deductible.  
  • Ask for the taxpayer’s calculation of MAGI.  Make sure that all addbacks are included, including losses deducted as non-passive by a real estate professional.    See Reg. § 1.469-9(j).

$25,000 Allowance Supporting Law

  • IRC § 469(i): $25,000 offset defined.
  • Madler T.C. Memo 1998-112:  Court ruled that taxpayers did not materially participate in their condo operation and stated that their level of participation did not even rise to the active participation standard.

Exceptions to Rental Definition

There are six exceptions to the definition of rental.  Under Reg. § 1.469-1T(e)(3)(ii), six types of activities normally defined as rentals, are treated as non-rental activities, i.e. as businesses, in most cases.  As a result, the active participation standard and the $25,000 allowance do not apply.  If the activity falls outside the rental definition, it is passive or non-passive based on whether the taxpayer materially participates.  Following are the six exceptions: 

  1. The average period of customer use is 7 days or less.  For example:  condo rentals, short-term use of hotel/motel rooms, and businesses that rent videos/tuxedos/cars/tools, etc.
  2. The average period of customer use is 30 days or less and significant personal services are provided with the rental.   Examples: hotels and motels.
  3. Extraordinary personal services are provided with the rental.  Examples: hospitals, nursing homes and boarding schools.
  4. The rental is incidental to a non-rental activity.
  5. The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers.  Example: golf courses, health clubs and spas.
  6. The taxpayer provides the property for use in a non-rental activity of his own partnership, S Corporation, or joint venture.  The key word here is “provides,” not “rents.”  For example: a partner contributes property in exchange for an ownership interest.  This non-leasing transaction with the partnership is not a rental.  Reg. § 1.469-1T(e)(3)(vii) states: “Thus, if a partner contributes the use of property to a partnership, none of the partner’s distributive share of partnership income is income from a rental activity…”  

Examination Techniques:

  • Determine the number of days of an average rental period in the activity.  Condo rentals falling under Exception #1 or #2 in Reg. § 1.469-1T(e)(3)(ii)  may be erroneously  entered on Form 8582, Lines 1b or 1c (for activities qualifying for  $25,000 allowance).  Since the activity is not defined as a rental, it is not eligible for the special rental real estate allowance and should be on Form 8582, line 3b.
  • Losses from activities meeting the exception to the rental definition are not automatically non-passive!  They are generally business activities.  The taxpayer must now meet the material participation standard to avoid designation as a passive activity.

Real Estate Professional In A Nutshell

Beginning in 1994, a real estate professional may treat rental real estate activities as non-passive if the taxpayer materially participates in the rental activities.[2]  The material participation requirement applies separately to each rental activity (unless the taxpayer made a timely election to group all his rentals as a single activity).  These rules apply to individual taxpayers and closely held C Corporations.  See checksheet and interview questions at end of chapter. 

Issues

  • To qualify as a real estate professional, the taxpayer must spend:
    1. more than 50 percent of his/her time in real estate activities; AND,
    2. more than 750 hours in real estate activities.
  • A real estate professional must materially participate in each rental activity for the loss to be deductible.[3]

Exception:  A real estate professional may file a written election to group all rental real estate activities as one activity. As a practical matter, most elections were filed in 1995.  However, the taxpayer may file the election in any year, and it will bind future years from that point.[4]

Issue Identification

  • Check to see if all Schedule E rental real estate losses have been deducted as non-passive, possibly not considering the fact that the taxpayer must materially participate in each rental activity.
  • Look at the taxpayer’s occupation next to the signature block and Schedule E line 43.  To be a real estate professional, the taxpayer must spend the majority of time[5] in real property businesses and/or rental real estate.
  • Review the Schedule E activities, Schedule K-1s for Form 1065 and Form 1120S returns, and W-2s for other indications regarding the nature of the taxpayer’s activities.

Real Estate Professional

To be a real estate professional, an individual must spend the majority of his or her time in real property businesses: 

  • Development or redevelopment
  • Construction or reconstruction
  • Acquisition or conversion
  • Rental
  • Management or operation
  • Leasing
  • Brokerage

The taxpayer must meet each of the following two time requirements:

  • More than 50 percent of his/her time working  in real property businesses; AND,
  • More than 750 hours of service during the year. [6]

One spouse alone must meet both tests. In addition, services performed as an employee do not count unless the employee is at least a 5 percent owner. 

Finally, before rental losses are deductible without being limited by the passive losses rules, the taxpayer must materially participate in each rental.[7]

Examination Techniques:

  • Determine whether the taxpayer materially participates in one or more of the specific real estate trades or businesses listed above.
  • Determine who is the real estate professional, husband or wife.
  • Request and closely examine the taxpayer’s documentation regarding time.  The taxpayer is required under Reg. § 1.469-5T(f)(4) to provide proof of services performed and the hours attributable to those services.  See Chapter 4 for more on methods of proof.
  • Scrutinize other activities the taxpayer is engaged in to determine whether time claimed makes sense.
  • Qualification as a real estate professional is a determination, not an election.  A taxpayer may attempt to manipulate the passive activity rules by inappropriately claiming to be a real estate professional, or conversely, by not claiming to be one (for instance, if certain activities are generating net income).

Material Participation for Real Estate Pros

A real estate professional may deduct rental real estate losses only to the extent he or she materially participates in each rental activity.  Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity.  Under the material participation rules, the time of both spouses is counted.[8]  The material participation test[9] then applies separately to each individual rental real estate activity.  If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive.  If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive and losses (or income) go on Form 8582.    

A taxpayer, who does most of the work in a rental, meets Test 2 for material participation in Reg. § 1.469-5T(a)(2).  However, if there is on-site management, it may be difficult for the taxpayer to materially participate because:

  1. Rental activities, by nature, normally do not require significant day-to-day involvement, i.e. they are not time intensive.
  2. For many taxpayers using any kind of outside management, the only material participation test available is the 500 hour test.  In many situations, the other tests will not apply.
  3. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity. 

Examination Techniques:   

  • During the initial interview, question the taxpayer regarding time spent in all activities (personal, business, civic, family, hobbies, etc).
  • Request and closely examine the taxpayer’s documentation of time utilized for material participation in each activity.  See the log-Chapter 5.
  • Look for time spent by others in the activity.  Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc. 

Election to Group Rental Real Estate

A real estate professional may make an election to group all rental real estate activities as one single activity.  In order to make a valid election, Treasury Regulation § 1.469-9(g) requires a taxpayer to file a written statement and attach it to an original return.  This election cannot be made on an amended return or during an audit!

Examination Techniques:

  • Question the taxpayer in the initial interview whether an election was made, grouping rental real estate interests as a single activity.
  • Request a copy of the return with the election.  Request the original Form 1040, U.S. Individual Income Tax Return, from the IRS Center if doubts exist as to the documents furnished.
  • Review prior and subsequent year’s returns for consistency.
  • Closely scrutinize any passive income on Form 8582 line 1a.  If the taxpayer is a real estate professional and did most of the work on the rental, gain on disposition does not belong on Form 8582.  

Real Estate Pro:  Law

  • IRC § 469(c)(7): Real estate professional defined (special rules for taxpayers in real property trades or businesses.
  • IRC § 469(c)(7)(A)(ii) and Reg. 1.469-9(e)(3): Each interest in a rental real estate activity is a separate activity for purposes of meeting the material participation tests.
  • Reg. § 1.469-9(g): Election available to group all rental real estate as one activity.  Must be a written statement filed on an original return.
  • IRC § 469(c)(7)(D)(i): Application of real estate professional rules to closely held C Corporations.

Equipment Rentals In a Nutshell

As a general rule, equipment rentals are defined as passive activities under IRC § 469(c)(2).  Income and losses should be entered on Form 8582, line 3 (All Other Passive Activities).  Rental activities are passive whether or not the taxpayer materially participates[10].  Material participation is generally irrelevant if the activity is a rental activity.  Unless a taxpayer meets one of the six exceptions[11] to the rental definition, neither the active participation standard nor the material participation standard apply.  As a result, the $25,000 allowance for rental real estate activities cannot be used for equipment rentals.  See equipment rental checksheet at end of chapter.

Issues

Equipment rentals generally are passive.  See IRC § 469(c)(2)&(4).

  • Since the activity does not involve rental real estate, the active participation standard and the $25,000 allowance do not apply.
  • Activities meeting one of the six exceptions are treated as businesses.  A taxpayer must then materially participate in order to treat the gain/loss as non-passive.   

Issue Identification

Equipment leasing activities are typically reflected on Schedules C & E as well as

Form 1065 & Form 1120S.  Business Code/NAICS Code 532400 is used for commercial and industrial machinery and equipment rental and leasing. 

Examination Techniques:

  • Request a copy of the lease.
  • If no written lease, determine if a true rental arrangement exists. 
  • Ask the taxpayer to explain what services, if any, the taxpayer provides with the equipment.
  • Request a copy of the management agreement or charter contract. 
  • Determine the average period of customer use.  If the rental activity falls under one of the six exceptions, request a detailed list of hours and services performed by the taxpayer. 
  • Request a statement from the taxpayer as to whether any activities have been grouped. 

Equipment Leasing Supporting Law

  • IRC § 469(c)(2) & (4):  Rental activities are passive regardless of whether the taxpayer materially participates.
  • Reg. § 1.469-1T(e)(3)(ii)(A)-(F):  Six exceptions to the definition of rental.  If an exception applies, the rental activity is treated as a business and the material participation rules apply.
  • Reg. § 1.469-1(e)(3)(iii):  Each period during which a customer has a continuous or recurring right to use the property is a separate period.  For example, if the property is used only a few hours at a time, but the lessee has a recurring right to use the property all year, the period of customer use is a year.
  • Reg. § 1.469-4(d)(1)(i):  General Rule: Rentals may not be grouped with businesses. 

Exceptions:

  1. a rental can be grouped with a business if insubstantial; or,
  2. owned in the exact same percentage and rented back to that business activity. 

Vacation Rentals In a Nutshell

Many condos, vacation cottages, time-shares, hotels, motels, and bed and breakfasts have an average rental period of seven days or less.  As a result, these activities are not defined as rentals[12], but instead are treated as businesses.  Net losses from these activities are passive unless the taxpayer materially participates.  Because many of these activities have a management company and may not be near to the taxpayer’s residence, materially participating[13] may be difficult.  See checksheet at end of chapter. 

Sub-Issues  

  • Activities with an average rental period of 7 days or less are defined as businesses, not rentals.  Therefore, the active participation standard and the $25,000 rental real estate allowance do not apply to these types of activities.  Losses, if passive, go on Form 8582 line 3b, not 1b.
  • The personal use rules IRC § 280A take precedence over IRC § 469.   If the taxpayer or family members spent more than 14 days at the property, losses generally are not allowed under the rules in IRC § 280A.   The losses do not enter into the passive activity computation and should not be entered on Form 8582.[14]

Issue Identification

  • Review Schedule E to determine the location of the activity.
  • Inquire about personal use, including family members or those renting at less than fair rental value.
  • Determine whether a management company has been hired for the day-to-day operations.  Indicators: commissions or management fees deducted.
  • Review Schedule C for short-term rentals.
  • Check the back of Schedule E for non-passive losses from hotels from flow through entities.  Does it make sense that the taxpayer materially participated in the partnership or S Corporation business?
  • Losses from businesses should be entered lines 3b, not 1b.  

Material Participation Sub-Issue

Taxpayers sometimes attempt to qualify as a material participant in a vacation rental under one of the following tests.

  • 100 hours and more than anyone else[15]: The taxpayer must not only prove he worked more than 100 hours, but more than anyone else.  He must be ready to provide evidence of the participation of others. Additionally, there is no provision in IRC § 469 to divide employee time by each unit.
  • Substantially all[16]:   It will be very difficult for the taxpayer to meet this test for any condo-type activity that either has a management firm or is located away from the taxpayer’s residence with someone who manages the activity.
  • Facts and circumstances[17]: This test cannot be used if anyone besides the taxpayer is paid to manage the activity.  An on-site management agency  disqualifies the taxpayer from using this test. 

For information on the material participation tests, see Chapter 4

Examination Techniques:

  • Tie down the taxpayer’s day-to-day involvement and specific hours regarding the activity.
  • Request, as soon as possible, a log or other documentation itemizing the nature of the participation and the hours for each type of work claimed during the year.  See log at end of Chapter 4.
  • Request a copy of any management or commission agreement.  Frequently, there is little left for the taxpayer to do.
  • Refer to Chapter 4 if significant time claimed for reading reports, paying bills or other investor-type hours, which are generally disregarded in the material participation tests.  Also see Chapter 4 for comments on travel.

IRC § 280A Sub-Issue

If a taxpayer or family members use a vacation property for more than 14 days or 10 percent of the property’s rental time, the personal use limitations of IRC § 280A apply and IRC § 469 is no longer applicable.  The IRC § 280A severely limits losses.  See

IRC § 469(j)(10) and Chapter 8 for more information on this issue. 

Examination Techniques:

  • Review Schedule E, Part I for information regarding personal use.
  • Request information verbally during the initial interview on time worked on the condo.
  • Also ask for any agreements with the management company.

IRC § 469(j)(7) Interest

Interest Expense on Rental of Personal Residence –   See Chapter 7

Summary

  • Up to $25,000 in rental real estate losses are allowed for taxpayers with MAGI of $100,000 or less[18].
  • The MAGI is adjusted gross income computed without any passive losses and several other minor modifiers.  When MAGI exceeds $150,000, rental losses are generally not permitted unless the taxpayer is a real estate professional.
  • A taxpayer who spends the majority of his time on real property businesses and rentals may deduct his rental real estate losses, if he materially participates in the rental.[19]
  • Equipment rentals are generally passive activities.  Losses are nondeductible in the absence of passive income.
  • Many vacation rentals fall outside the rental definition[20] and are treated as businesses.  If there is on-site management, it may be difficult for the taxpayer to meet the material participation standard.

[1] IRC § 469(c)(2)&(4)

[2] IRC § 469(c)(7)

[3] Reg. § 1.469-9(e)(1)

[4] Reg. § 1.469-9(g)

[5] The majority of time he or she spends performing personal services in trade or businesses must be in real property trades or businesses.  IRC § 469(c)(7)(B).  

[6] IRC Section § 469(c)(7)(B)

[7]If the taxpayer elected to group his rentals as a single activity  under the provisions of Reg. § 1.469-9(g), then he must prove material participation in the grouped rental activity .  

[8] IRC § 469(h)(5), Reg. § 1.469-5T(f)(3) and Reg. § 1.469-1T(j) 

[9] Reg. § 1.469-5T(a) 

[10] IRC § 469(c)(2)&(4) 

[11] Reg. § 1.469-1T(e)(3)(ii) 

[12] Reg. § 1.469-1T(e)(3)(ii)(A) 

[13] Reg. § 1.469-5T(a) 

[14] IRC § 469(j)(10)

[15] Reg. § 1.469-5T(a)(3)

[16] Reg. § 1.469- 5T(a)(2)

[17] Reg. § 1.469-5T(a)(7) & (b)(2)

[18] IRC § 469(i)

[19] IRC § 469(c)(7) and Reg. 1.469-9(e)(1)  

[20] Reg. §1.469-1T(e)(3)(ii)(A) 

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Page Last Reviewed or Updated: 04-Mar-2014