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Before enactment of the Tax Reform Act of 1986, few limitations were placed on the ability of a taxpayer to use deductions from one activity against income from other activities. This led to the popularity of tax shelters, designed to produce substantial tax losses and credits that could be used against positive income from sources such as salary, interest, and dividends. In response to concerns about the real and perceived fairness of the income tax system, as well as concerns about the economic merits of investments that were being made, Congress introduced the passive activity loss (PAL) rules in 1986. The central theme behind the PAL rules was that losses from passive activities cannot be used to offset nonpassive income such as salary, business income, interest and dividends. These complex rules introduced such concepts as material participation, active participation, portfolio income, and undertaking to name a few, and have resulted in volumes of regulations providing further complexities.

A general rule inherent in the original PAL provisions was that all rental activities are "passive," regardless of an individual's level of involvement in that activity or in real estate activities in general. As a result, if rental realty produces a tax loss, its owner cannot use the loss to offset nonpassive income with the exception of a $25,000 loss allowance for individuals with adjusted gross income under $100,000 and subject to a phase-out provision up to $150,000 of adjusted gross income. Beginning in 1994, more liberal PAL rules were introduced for qualifying real estate professionals, i.e., those who "materially participate" in a real property business. If you are one of them, your rental real estate properties generally are treated like any other non-rental activity business. As a result, if you materially participate in a real property business, losses generated by the business aren't branded with the "passive" label and you can use the losses to offset nonpassive income.

So how does one qualify for this exemption? First, more than half of the personal services you or your spouse perform in all businesses during the year must be performed in real estate businesses in which you materially participate. Secondly, your personal services in material participation real property businesses during the year must amount to more than 750 hours. Real property businesses include such enterprises as construction, development, buying, renting, operating, managing and leasing realty, as well as realty brokerage businesses. Personal services you perform as an employee in real property trades or businesses do not count unless you are a 5% or more owner of the business. In order to meet the standard of material participation, your involvement in the operations of the activity must be regular, continuous, and substantial. Extensive rules apply in determining whether a taxpayer's participation is regular, continuous, and substantial. Generally, objective tests are applied, and the standard is met if you participate in the activity for more than 500 hours during the taxable year, you are substantially the only participant in the activity, or you meet one of several other tests.

Only real property trades or businesses in which you materially participate are considered for these tests. These tests are applied annually. This means that you may qualify for the exception in some years but not in other years. As a result, the same real estate activity may generate passive losses in some years and nonpassive losses in other years. If a joint return is filed, both requirements must be satisfied by the same spouse. However, you can count your spouse's participation in an activity in determining if you materially participate in the same activity.

Like many exceptions to difficult tax rules, the real estate professional's exception carries a number of complications. For example, a real estate property in which you are a material participant may carry suspended losses from years in which you didn't qualify as a real estate professional. This type of property is treated as a former passive activity, which means that the suspended losses can only offset income from the activity that produced the loss, or passive income from other investments. In general, the suspended losses cannot be used to offset nonpassive income until the property is sold.

For purposes of applying the PAL rules, you can choose to combine all of your rental real estate activities into one activity, or treat each one separately. This election may be advantageous in the case of a rental real estate property which carries previously disallowed losses. Without the election, these suspended losses may only be offset by future income from the same property. However, the election to aggregate all rental properties provides the opportunity to offset suspended losses from one property with income from another. On the otherhand, the aggregation election can be a liability if a formerly passive rental real estate property carries large previously disallowed losses that are not likely to be absorbed by income from other real estate properties, or if the qualifying real estate professional wants to sell the loss property. The reason is that the election applies for all PAL purposes, including the disposition rules. As a result, the previously disallowed losses won't be released when the property that produced the loss is sold, unless the property represents substantially all of the aggregated activity. Without the election, the previously disallowed losses from the former passive activity would be released if the property that generated them were sold.

The election to combine activities can be made in any year in which you qualify under the real estate professional rules. The election is binding for the tax year for which it is made and for all future years in which the qualified real estate professional requirements are satisfied, and may be revoked only in the tax year in which there is a material change in your facts and circumstances. Therefore, you should evaluate the circumstances carefully before making the aggregation election.

As you can see, there are significant planning opportunities available to individuals meeting the real estate professional requirements. Please contact our Real Property Group for more information about tax planning opportunities for real estate professionals.

- John Launceford, CPA, MS (Tax), CVA