Our tax law puts your income and deductions into three separate buckets for tax purposes. Each bucket has its own rules and regulations. These are the three buckets:
A real estate rental is automatically in the passive bucket if you do not qualify as a real estate professional. If your real estate rental is in the passive bucket, the bucket has a lid on it that limits rental property loss deductions against anything other than passive income. This is a bad bucket.
For your rental property to escape the passive loss bucket, you need to both
1. qualify as a real estate professional, and
2. materially participate in the rental property.
The two tests were the subject of the Agarwal case (Shri G. Agarwal v Commr., T.C. Summary Opinion 2009-29). If you own or expect to own rental properties, you will find the following discussion of the Agarwal case instructive.
Mr. and Mrs. Agarwal deducted real estate rental property losses (passive losses) of $40,104 and $19,656 against their active and portfolio buckets. (This means that losses from the rentals were calculated on their Schedule E and those losses were carried to the front page of the Form 1040 as escapees from the passive loss bucket.)
On the front page of the Form 1040, the real estate losses offset the income that Mr. Agarwal earned as an engineer in addition to the other income items that appeared on the Form 1040. The after-tax cash benefit from the losses was about $24,000, and that was the amount the IRS wanted back.
During the years these losses were incurred, Mrs. Agarwal worked full time as a real estate agent at Century 21 Albert Foulad Realty. In court, she and her husband argued that real estate agents should be considered real estate professionals because they are in the brokerage business, bringing together buyers and sellers.
The IRS argued that Mrs. Agarwal was a licensed real estate agent, not a licensed real estate broker. According to the IRS, California law placed Mrs. Agarwal in the “real estate agent” category; therefore, she could not be engaged in a brokerage trade or business. Without brokerage status, Mrs. Agarwal did not have sufficient work time to qualify as a real estate professional and the losses would not be deductible against other income.
Real Estate Activities
In her capacity as a real estate agent, Mrs. Agarwal was an independent contractor. She received a Form 1099 for her commissions. She did not receive a salary.
The independent contractor agreement required Mrs. Agarwal to sell, exchange, lease, or rent properties and to solicit additional listings, clients, and customers diligently, using her best efforts.
For the years at trial, Mrs. Agarwal reported
- year 1 real estate agent commissions of $13,912 and expenses of $14,084, for a $172 loss; and
- year 2 real estate agent commissions of $14,119 and expenses of $13,401, for a $718 profit.
Mrs. Agarwal spent a total of 1,400 hours in year 1 and 1,600 hours in year 2 managing the rental properties and selling real estate. The Agarwals owned two rentals and spent about 170 hours of management time on each property during each of the two years at issue. They were the only persons who managed their rental properties.
For year 1, the Agarwals reported rents of $36,367 and expenses of $76,472, for a $40,105 loss. For year 2, they reported rents of $45,521 and expenses of $65,177 for a $19,656 loss.
Tax law treats all real estate rental activities as automatically passive for all taxpayers except qualifying real estate professionals. If passive, the rental property losses are flat-out not deductible against any income other than passive income. In this passive category, material participation is irrelevant.
Escape. The only escape from the rental property passive loss disallowance rule is for either you or your spouse to individually qualify as a real estate professional.
You qualify as a real estate professional if
- more than one-half of your personal services are in real property trades or businesses in which you materially participate; and
- you perform more than 750 hours of services during the taxable year in real property trades or businesses in which you materially participate.
Tax law defines the term “real property trade or business” as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
For material participation, the regulations contain seven different tests. Pass any one of the seven for a property, and you are deemed to materially participate in that property (unless you elected to include this property in a group). To review the seven tests for material participation, go to page 4 of IRS Publication 925, Passive Activity and At- Risk Rules (2008) at http://www.irs.gov/pub/irs-pdf/p925.pdf.
The Brokerage Question
The court concluded that for purposes of the passive loss rules, the “business” of a real estate broker includes, but is not limited to,
- selling, exchanging, purchasing, renting, or leasing real property;
- offering to do those activities listed above;
- negotiating the terms of a real estate contract;
- listing real property for sale, lease, or exchange; or
- procuring prospective sellers, purchasers, lessors, or lessees.
Mrs. Agarwal lived and worked in California. California law defines the term “real estate broker” as a person who does, or negotiates to do, any one of the above activities for compensation.
California law defines the term “real estate salesperson” (agent) as a person who is employed by a broker and who does any one of the above activities.
The court noted that although California law characterized Mrs. Agarwal as a salesperson and not as a broker, she was in fact engaged in the brokerage business for passive loss purposes because she sold, exchanged, leased, rented, and solicited listings for real property.
The Material Participation Question
Unlike real estate professional status, which requires either the husband or the wife to meet the tests, the material participation rules allow for a combination of the husband’s and the wife’s work efforts.
Mrs. Agarwal and her husband qualified under two of the seven tests for material participation in the properties. To qualify as material participants, they had to pass only one of the tests. Here we explain both, as they provide good insight:
Test 1. Their participation in the rentals constituted substantially all the participation. (They were the only participants; accordingly, they passed this material participation standard.)
Test 2. Mrs. Agarwal and her husband’s combined participation of 170 hours exceeded 100 hours and was at least as great as that of any other participant. (They did this for each of the properties; accordingly, they passed this material participation standard.)
The court simply said that the Agarwals met the material participation standard and did not elaborate. We provided the elaboration above for clarity on these sometimes confusing rules.
The Court’s Ruling
The court ruled that Mrs. Agarwal is a real estate professional because she both performed more than one-half of her personal services in real property trades or businesses in which she materially participated, and performed more than 750 hours of services in real property trades or businesses in which she materially participated.
This is great. Real estate professional status eliminates the automatic classification of the real estate rentals as passive activities.
Because she is a real estate professional, Mrs. Agarwal may deduct her rental losses against her other buckets if she materially participates in those properties.
As we explained above, the Agarwals did meet the material participation standards with respect to each of their two rental properties.
Thus, Mrs. Agarwal wins her passive loss deductions because she was a real estate professional who materially participated in her rentals. She and her husband keep their $24,000 in tax benefits. The best possible outcome!