Rental activities are passive by default under section 469, so rental losses generally offset only passive income. A taxpayer who qualifies as a real estate professional can treat rental real estate as non-passive, which can free large losses, often from cost segregation. The IRS knows this, and the claim rises or falls on records the client usually has not kept. Build the log before year end, not in March.
The statutory test
Section 469(c)(7)(B) sets two requirements for the taxable year:
- More than one-half of the personal services the taxpayer performs in trades or businesses during the year are performed in real property trades or businesses in which the taxpayer materially participates.
- The taxpayer performs more than 750 hours of services during the year in those real property trades or businesses.
Both must be met. Real property trades or businesses include development, construction, acquisition, conversion, rental, operation, management, leasing and brokerage.
Why the first test catches people
The first test compares real estate hours with all hours worked in every trade or business. A client who works 2,000 hours a year as an employee or in an operating company would need more than 2,000 hours in real estate to meet the more-than-half test. Under section 469(c)(7)(D)(ii) and Treas. Reg. 1.469-9(c)(5), services performed as an employee count as services in a trade or business but not as services in a real property trade or business, unless the employee owns more than 5 percent of the employer (a five-percent owner under section 416(i)(1)(B)). So a full-time employed client with rental properties on the side rarely qualifies.
A spouse might. For a joint return, the requirements are met if and only if either spouse separately satisfies them (section 469(c)(7)(B), last sentences). The two spouses' hours are not added together for the 750-hour and more-than-half tests. Spouses' hours are combined only for the later question of material participation, because Treas. Reg. 1.469-5T(f)(3) treats a spouse's participation as the taxpayer's own.
Material participation is a separate step
Qualifying as a real estate professional only removes the automatic passive label on rental activity. Under Treas. Reg. 1.469-9(e)(1), a qualifying taxpayer's rental real estate is still passive unless the taxpayer materially participates in it. Each interest in rental real estate is a separate activity unless the taxpayer elects under section 469(c)(7)(A) to treat all interests as one.
A client with eight rentals who spends 100 hours on each reaches 800 hours in aggregate but never more than 500 hours in any single property. Without the election each property is tested alone; with it, the 800 hours are tested as one activity. The most common test, Treas. Reg. 1.469-5T(a)(1), requires more than 500 hours in the activity. The election is made by a statement filed with the original return (Treas. Reg. 1.469-9(g)(3)). It is binding for the year made and for every later year in which the taxpayer is a qualifying taxpayer, and it can be revoked only after a material change in facts. Decide it before the first year it matters.
The log
Treas. Reg. 1.469-5T(f)(4) allows hours to be shown by any reasonable means and says contemporaneous daily time reports are not required if other reasonable means exist, such as appointment books, calendars or narrative summaries identifying the services and the approximate hours. The regulation sets the floor. A log kept at the time of the work is the best way to meet it, because a reconstruction made once the examination letter arrives has nothing behind it. A usable log has:
- Date, hours, the property or activity, and a specific description of the work, for example "met contractor at 410 Elm to scope unit 3 rehab, 2.5 hours."
- Entries made at or near the time of the work, from a calendar, a property management system or a time app.
- A separate record of hours spent on any other job, so the more-than-half comparison can be shown.
- Supporting evidence such as emails, invoices, mileage logs and text messages with tenants and vendors.
Work done as an investor, such as reviewing financial statements or monitoring finances, does not count as participation unless the taxpayer is directly involved in day-to-day management or operations (Treas. Reg. 1.469-5T(f)(2)(ii)). The same exclusion applies to the 750-hour count through Treas. Reg. 1.469-9(b)(4).
Worked example one: a full-time employee
A client owns four rentals and works 1,100 hours as a hospital administrator. She logs 900 hours on her rentals.
- Test 1: real estate hours are 900 of 2,000 total hours, or 45 percent. That is not more than one-half. She fails.
- If she cut the hospital job to 600 hours and still logged 900 on rentals: real estate is 900 of 1,500, or 60 percent, and 900 exceeds 750. Both parts pass.
The same facts pass or fail on how many hours she works elsewhere, which is why the log must capture all work, not just real estate.
Worked example two: a joint return
Spouse A works 2,100 hours as a W-2 employee and logs 120 hours on the couple's rentals. Spouse B has no other job and logs 840 hours managing and repairing the rentals, and materially participates in them.
- Spouse B alone: 840 of 840 total hours is 100 percent, and 840 exceeds 750. Spouse B satisfies both requirements, so the couple's joint return qualifies.
- If Spouse B logged only 700 hours, B would fail the 750-hour test. Adding Spouse A's 120 hours to reach 820 does not help, because the hours are not combined for this test.
Common errors
- Counting hours as an employee of an unrelated company as real estate hours.
- Adding both spouses' hours to reach 750.
- Logging total hours without separating by property when no aggregation election was filed.
- Counting investor-type work such as reviewing statements.
- Filing the aggregation election late, or forgetting that it carries into later years.
What to put in the file
- Annual hours summary by property and by category of work, with the underlying log.
- A statement of the client's other employment, with an estimate of annual hours and the source.
- The aggregation election statement, if made.
- A conclusion memo citing section 469(c)(7)(B) and the facts that support each element.
- For clients who are not real estate professionals, the active participation analysis in the $25,000 rental loss allowance.
Sources
- Legal Information Institute, 26 U.S.C. 469, Passive activity losses and credits limited: https://www.law.cornell.edu/uscode/text/26/469
- Internal Revenue Service, Publication 925, Passive Activity and At-Risk Rules: https://www.irs.gov/publications/p925
- Legal Information Institute, 26 CFR 1.469-9, Rules for certain rental real estate activities (qualifying taxpayer, election statement): https://www.law.cornell.edu/cfr/text/26/1.469-9
- Legal Information Institute, 26 CFR 1.469-5T, Material participation (methods of proof, investor work, spouse participation): https://www.law.cornell.edu/cfr/text/26/1.469-5T
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