Read part one of Michael’s article Qualifying as a Real Estate Professional
So how does one qualify as an REP? First, a person must materially participate in a real property trade or business. The IRS has defined real property trade or businesses as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” Second, more than 50 percent of the personal services a person performs in all businesses during the year must be performed in real estate businesses in which an REP materially participates. Third, personal services in material participation of real property businesses during the year must amount to more than 750 hours. For these purposes, a person generally can’t count any work performed in the capacity as an investor.
In determining whether a person qualifies as an REP, each of their rental real estate interests is treated as a separate activity—that is, as a separate business—unless a grouping election is made to treat all those interests as a single activity. Because of this rule, if someone has multiple rental properties, and they don’t make the election, they must establish material participation for each property separately. They also must satisfy the “more-than-50 percent” test and the 750-hours test for each property separately in order to qualify as a REP with respect to that property.
Qualifying for one property wouldn’t mean someone qualifies for any property. Thus, if an REP doesn’t make the grouping election, qualifying for all properties becomes more difficult (and may become impossible) as the number of properties increases. But if an REP does make the election, they only have to establish material participation — and satisfy the more-than-50 percent test and the 750-hours test — or the combined properties as a whole. The IRS is allowing taxpayers a one-time opportunity to reconsider their grouping elections, the year they first become subject to the NIIT.
What’s material participation in an activity?
Material participation in an activity means involvement in the operations of the activity on a regular, continuous and substantial basis. The typical ways an individual can establish material participation in a real estate activity are as follows:
• Participating in the activity for more than 500 hours in the tax year (the most frequently utilized test),
• Participating in the activity if the taxpayer’s participation is substantially all of the participation in that activity by any individuals (including non-owners),
• Participating in the activity for more than 100 hours in the tax year, if nobody else (including non-owners) participated more,
• Having materially participated in the activity during any five of the ten tax years before the year at issue, or
• Showing regular, continuous and substantial participation on the basis of all the relevant facts and circumstances, but only if more than 100 hours of participation during the tax year can be shown.
Qualifying for tax purposes as an REP is not an easy matter. The rules are complex. Grouping elections need to be evaluated before being made (as in some cases there is a downside to making a grouping election). Trade or business determinations may need to be made for properties, and the record keeping necessary to establish the requisite time spent in each business activity is burdensome but necessary. Taxpayers looking to qualify as an REP must carefully document the number of hours by activity that they spend on real estate and non-real estate activities.
Michael A. Mongelli is a director at BST. He is actively involved in the firm’s Real Estate Industry Services group working with closely held businesses and their owners on individual, partnership, and corporate tax issues.
Posted on January 24, 2014 at 9:05 PM