Separate Activity Treatment does not affect passive loss for real estate professionals
In Chief Counsel Advice (CCA), IRS has concluded that a taxpayer’s failure to make the election under to treat all rental real estate activities as one activity doesn’t affect the application of the passive activity loss (PAL) real estate professional test.
The implications of this are profound for real estate professionals. The IRS used to disqualify any real estate losses for individuals who failed to elect to treat all real estate as one activity and thus their losses would be lost. While they still try to do this, they cannot do it if the taxpayer is a real estate professional.
Background. Under the PAL rules, losses from passive activities may only be used to offset passive activity income. Thus, such losses can’t be used to offset income from, for example, compensation, interest or dividends.
Under, the PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. A taxpayer is treated as materially participating in an activity if he meets at least one of the seven tests in. Under one of those tests, an individual will be treated as materially participating in an activity for a tax year if the individual participates in the activity for more than 500 hours during such year.
In general, any rental activity is per se a passive activity regardless of the taxpayer’s participation in the activity. However, there are exceptions to the general per se rule. Where an exception applies, a rental real estate activity is not a passive activity for the tax year if the taxpayer materially participates in the activity.
Under the per se rule for rental activities doesn’t apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if: (1) more than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and (2) he performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates.
If a taxpayer is a qualifying real estate professional, the PAL rules generally are applied as if each interest of the taxpayer in real estate were a separate activity. This would have the effect of separating real estate losses from gain which is undesirable for tax purposes. For example, the determination of whether the taxpayer materially participates is applied separately to each interest. But, a real estate professional may elect to treat all his interests in rental real estate as one activity, if he makes the election in his tax return. Failure to make this election creates the problem of on non deductible losses unmatched to the gains.
“Real property trade or business” means “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” The determination of a taxpayer’s real property trades or businesses is based on all of the relevant facts and circumstances. That reg also provides that, depending on the facts and circumstances, a real property trade or business consists either of one, or more than one, trade or business specifically described in.
Under and, only time spent in real property trades or businesses in which the taxpayer materially participates under counts towards meeting the requirements of being a real estate professional.
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