In computing taxable income, losses at, tributable to passive activities may not offset income which is not derived from passive activities. Rather, losses from a passive activity are "suspended" until the taxpayer either realizes passive income or disposes of his entire interest in the passive activity to an unrelated person. By contrast, losses from a trade or business in which the taxpayer materially participates ("active" losses), may be applied against any sort of income.
Passive activities generally include only those trade or business activities in which the taxpayer does not "materially participate." Rental activities, however, were passive per se prior to the Omnibus Budget Reconciliation Act of 1993. This placed taxpayers who engage in real estate rental as a primary business activity in an unfair position relative to business people in other fields. Losses from a rental real estate business, regardless of the taxpayer's level of participation in the rental business, could not offset other income, even if that income was derived from nonrental real estate activities (such as property management,, or development). The usual result was currently taxable income from nonrental activities and a stockpile of passive loss carryovers.
The 1993 Act provided significant relief to taxpayers engaged in rental real estate businesses. If a taxpayer qualifies for this relief, then his or her rental real estate activities are not automatically deemed passive. Instead, if a qualifying taxpayer materially participates in rental real estate activities, then the income and losses from those activities are nonpassive, and the taxpayer's ability to use losses generated by such rental real estate activities is not limited by the passive loss rules.
The 1993 amendment was made effective for taxable years beginning in 1994 and thereafter. However, ambiguities in the drafting of the relief provision made its scope uncertain and its utility was correspondingly limited. On Jan. 9, 1995, the Internal Revenue Service proposed Regulations clarifying some aspects of the 1993 legistation. These Regulations will greatly facilitate income tax planning by real estate professionals.
Qualification for the relief provided by the 1993 Act requires that the taxpayer's services in real property trades or businesses (including, but not limited to, rental real estate activities) in which the taxpayer materially participates must (i) constitute more than 50% of the taxpayer's personal services performed in all trades or businesses during that year and (ii) consist of more than 750 hours of services. This dual test is applied each year. For purposes of qualifying under the dual test, the statute defines "real property trade or business" broadly, as including any real property development, redevelopment,, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Personal services performed as an employee are not treated as performed in a real property trade or business unless the employee owns 5% or more of the employer. In order for married taxpayers filing a joint return to qualify, one of the two spouses must pass both tests individually; however, in determining whether a spouse has materially participated in a given activity, the time spent by both spouses in that activity is aggregated.
Rules should facilitate qualification
As noted above, in order to fulfill the dual requirements of "more than 50% of total services" and "more than 750 hours," the taxpayer's time must be spent in real property trades or businesses in which the taxpayer materially participates. Although a taxpayer may have spent more than 750 hours in real estate trade or business activity, the taxpayer may fail to participate materially in any of the activities and may not qualify for the new relief if these hours are broken up among many different activities. The new proposed Regulations make clear that a taxpayer may use "any reasonable method" of grouping his real property trades or businesses for purposes of determining whether he meets the dual test, apparently without regard to the rules generally applicable to aggregation of activities for passive loss purposes. This should facilitate qualification for the relief provided by the 1993 Act in the case of many taxpayers.
After determining that a taxpayer qualifies under the dual test, a second determination of material participation must be undertaken in order to apply the operative provisions of the passive loss rules to the taxpayer's rental real estate activities. For purposes of this second determination, each interest in rental real estate must be treated as a separate activity, unless the taxpayer specifically elects to treat all such interests as one activity. A taxpayer may not choose to aggregate only some of his interests in rental real estate, but instead must either treat each interest in rental real estate as a separate activity or elect to aggregate into a single activity all of the rental real estate in which he owns an interest. Thus, if during a taxable year a taxpayer has income from one property and losses from two others and has spent 400 hours on each property, he may not aggregate only the two loss properties in order to apply the losses against other income without first offsetting the income from the third property. The proposed Regulations, however, add a special rule under which a less-than-50% partner in a partnership may in some circumstances be permitted to aggregate only interests held through that particular partnership.
The 1993 Act also provides that the special rule permitting a taxpayer to elect to aggregate all of his rental real estate endeavors cannot be used in determining material participation with respect to limited partnership interests. The proposed Regulations interpret this to mean that the aggregation election, if made, may (indeed must) include limited partnership interests; however, if such limited partnership interests are included, material participation in the overall, aggregated activity will be determined under the standards applicable to limited partners, rather than under the more liberal standards applicable to other investors. In general, this will mean that the taxpayer must participate in rental activities for more than 500 hours per year, without the opportunity to demonstrate, as a nonlimited partner could, that participation of less than 500 hours was nevertheless "regular, continuous, and substantial" and, therefore, material. An exception is provided in the case of taxpayers whose gross rental income from limited partnership interests is less than 10% of their gross rental income from all sources.
Taxpayer must meet dual test
Time spent in activities in which the taxpayer does not materially participate or which are not real property trades or businesses will not count towards fulfilling the requirements of the dual test. In fact, time spent on nonqualifying activities will make it more difficult for the taxpayer to meet the dual test, since, by adding to the total number of hours of personal services, the taxpayer increases the threshold necessary to qualify half of his time in real estate activities. Bear in mind that, even if the taxpayer satisfies the dual test of the new relief provisions, losses from activities in which the taxpayer does not materially participate will still be passive losses.
Pre-1994 passive loss carryovers attributable to rental real estate activities which are subject to the new rules are treated like "former passive activity" carryovers and may offset only income from the activity in which they arose or other passive income. They are not recharacterized as losses from a nonpassive activity.
As this summary indicates, there are some rather strict and confusing requirements for satisfying the new rules, and there also may be cases in which rental activities of a taxpayer who does satisfy the dual test of the 1993 Act will still be passive due to a lack of material participation. One should, therefore, be aware that the 1993 Act's passive loss relief provision, even as interpreted by the new proposed Regulations, is not necessarily all it's cracked up to be. However, in appropriate cases substantial relief has been provided to real estate professionals.
Ronald A. Morris and Elliot Pisem, members of the New York bar, are partners in the law firm of Roberts & Holland, New York City and Washington, D.C.