Thursday, March 7, 2019
Tuesday’s post was the first installment in a series of blog posts on the passive loss rules of I.R.C. §469. In that post, I noted that under I.R.C. §469, a taxpayer is limited in the ability to use losses from passive activities against income from a trade or business that the taxpayer is engaged in. In that post, I noted that a passive activity includes trades and businesses in which the taxpayer does not materially participate. Active participation provides a limited ability to deduct losses.
While a rental activity is normally treated as “per se” passive by presumption, if the taxpayer is deemed to be a “real estate professional” then the presumption is overcome, and the taxpayer will be treated as non-passive if the taxpayer materially participates in the rental activity.
The rule that rents are presumed to be passive is also a concern because of the Net Investment Income Tax (NIIT). I.R.C. §1411. The NIIT imposes an additional tax of 3.8 percent on passive income, including passive rental income.
The real estate professional test of the passive loss rules – that’s the topic of today’s post.
History and Basics of the Rule
As noted in Tuesday’s post, the passive loss rules of I.R.C. §469 became effective for tax years beginning after December 31, 1986. As originally enacted, a passive activity was defined to include any rental activity regardless of much the taxpayer participated in the activity. This barred rental activities from being used to shelter the taxpayer’s income from other trade or business activity. Rental activities could often produce a tax loss particularly due to depreciation deductions while the underlying property simultaneously appreciated in value. The rule was particularly harsh on real estate developers with multiple development projects. One project would be developed and sold while another project would be rented out. In this situation, the developer had two activities - one that was the taxpayer’s trade or business activity (non-passive); and one that was a rental activity (passive). This produced a different result, for example, from what a farmer would achieve if the farmer lost money on the livestock side of the business while making money on the crop portion. In that situation, the livestock loss would offset the crop income.
To address this perceived inequity, the Congress amended the passive loss rules to provide a narrow exception to the per se categorization of rental activities as passive. Under the exception, a “real estate professional” that materially participates in a rental activity is not engaged in a passive activity. I.R.C. §469(c)(7). Thus, rental activities remain passive activities unless the taxpayer satisfies the requirements to be a real estate professional.
To be a real estate professional two tests must be satisfied: (1) more that 50 percent of the personal services that the taxpayer performs in trades or business for the tax year must be performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. I.R.C. §469(c)(7). If the two tests are satisfied, as noted above, the rental activity is no longer presumed to be passive and, if material participation is present, the rental activity is non-passive. I.R.C. §469(c)(7)(A)(i).
The issue of whether a taxpayer is a real estate professional is determined on an annual basis. See, e.g., Bailey v. Comr., T.C. Memo. 2001-296.
What is a Real Property Trade Or Business?
To qualify for the real estate professional exception, the taxpayer must perform services in a real property trade or business. Obviously, production agriculture involves farm and ranch land. This raises a question as to the types of business associated with farming and ranching that could be engaged in a real property trade or business for purposes of the passive loss rules. Under I.R.C. §469(c)(7)(C), those are: real property development; redevelopment construction; reconstruction; acquisition; conversion; rental; operation; management; leasing; or brokerage.
Mortgage brokers and real estate agents present an interesting question as to whether they are engaged in a real estate trade or business. In general, a mortgage broker is not deemed to be engaged in a real property trade or business for purposes of the passive loss rules. That’s the outcome even if state law considers the taxpayer to be in a real estate business. What the courts and IRS have determined is that brokerage, to be a real estate business, must involve the bringing together of real estate buyers and sellers. It doesn’t include brokering financial instruments. See, e.g., Guarino v. Comr., T.C. Sum. Op. 2016-12; C.C.A. 201504010 (Dec. 17, 2014). The definition of a real estate trade or business also does not include mortgage brokering. See, e.g., Hickam v. Comr., T.C. Sum. Op. 2017-66. But, if a licensed real estate agent negotiates real estate contracts, lists real estate for sale and finds prospective buyers, that is likely enough for the agent to be deemed to be in a real estate trade or business for purposes of the passive loss rules. See, e.g., Agarwal v. Comr., T.C. Sum. Op. 2009-29.
A licensed farm real estate appraiser might also be determined to be in a real estate trade or business if the facts are right. See, e.g., Calvanico v. Comr., T.C. Sum. Op. 2015-64. A real estate appraisal business involves direct work in the real estate industry. But, associated services that are only indirectly related to the trade or business of real estate (such as a service business associated with real estate) would not seem to meet the requirements of I.R.C. §469(c)(7). Indeed, this is the position the IRS has taken in its audit technique guide for passive activities. See IRS Passive Activity Loss Audit Technique Guide at www.irs.gov/pub/irs-mssp/pal.pdf
What about a taxpayer that works for a farm management company? The services of a farm management company are a bit different than a real estate management company that is engaged in the real estate business. See, e.g., Stanley v. United States, No. 5:14-CV-05236, 2015 U.S. Dist. LEXIS 153166 (W.D. Ark. Nov. 12, 2015), nonacq., A.O.D. 2017-07 (Oct. 16, 2017). But, perhaps services performed that directly relate to the real estate business would count – putting together rental arrangements, managing the leases, dealing with on-farm tenant housing, etc. Economic related services such as cropping and livestock decisions would seem to not be real estate related. In any event, the taxpayer would need to be at least a five percent owner of the farm management company for the taxpayer’s hours to count toward the I.R.C. §469(c)(7) tests. I.R.C. §469(c)(7)(D)(ii); Treas. Reg. §1.469-9(c)(5).
Importantly, a real property trade or business can be comprised of multiple real estate trade or business activities. Treas. Reg. §1.469-9(d)(1). This implies that multiple activities can be grouped together into a single activity. That is, indeed, the case. Treas. Reg. §1.469-4 allows the grouping of activities that represent an “appropriate economic unit.” Under that standard, non-rental activities cannot be grouped with rental activities. Treas. Reg. §1.469-9(g) allows a real estate professional to group all interests in rental activities as a single activity. If this election is made, the real estate professional can add all of their time spent on all of the rental activities together for purposes of the 750-hour test.
In Chief Counsel Advice 201427016 (Apr. 28, 2014), the IRS stated that the Treas. Reg. §1.469-9(g) aggregation election “is relevant only after the determination of whether the taxpayer is a qualifying taxpayer.” Thus, whether a taxpayer is a real estate professional for purposes of the passive loss rules is not affected by an election under Treas. Reg. §1.469-9(g). In other words, the election under Treas. Reg. 1.469-9(g) has no bearing on the issue of whether a taxpayer qualifies as a real estate professional – puts in more than 750 hours in real estate activities and satisfies the 50 percent test. See also Miller v. Comr., T.C. Memo. 2011-219. But, grouping can make it easier for the taxpayer to meet the required hours test of I.R.C. §469(c)(7) and be deemed to be materially participating in the activity.
Regroupings are not allowed in later years unless the facts and circumstances change significantly, or the initial grouping was clearly not appropriate. Treas. Reg. §1.469-9(d)(2).
The IRS has taken the position that only an individual can be a real estate professional for purposes of the passive loss rules. C.C.A. 201244017 (Nov. 2, 2012). That’s important as applied to trusts. Much farm and ranch land that is rented out is held in trust. That would mean that the only way the trust rental income would not be passive is if the trustee, acting in the capacity as trustee, satisfies the tests of I.R.C. §469(c)(7). The one federal district court that has addressed the issue has rejected the IRS position. Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). The Tax Court agrees.
In Frank Aragona Trust v. Comr., 142 T.C. 165 (2014), a trust incurred losses from rental activities which the IRS treated as passive. The trust had six trustees – the settlor’s five children and an independent trustee. One of the children handled the daily operation of the trust activities and the other trustees acted as a managing board. Also, three of the children (including the one handling daily operations) were full-time employees of an LLC that the trust owned. The LLC was treated as a disregarded entity and operated most of the rental properties. The trust had essentially no activity other than the rental real estate. The IRS, in treating the losses as passive said that the trustees were acting as LLC employees and not as trustees. The Tax Court disagreed with the IRS position, finding that the trust materially participated in the rental real estate activities and that the losses were non-passive. The trustees, the Tax Court noted, managed the trust assets for the beneficiaries, and if the trustees are individuals and work on a trade or business as part of their duties, then their work would be “performed by an individual in connection with a trade or business.” Thus, a trust, rather than just the trustees, is capable of performing personal services.
The Tax Court’s position in Frank Aragona Trust could be particularly important in agriculture. A great deal of leased farm ground is held in trust. The trust will be able to meet the material participation standard via the conduct of the trustees. That will allow full deductibility of losses. In addition, the trust income will not be subjected to the additional 3.8 percent tax of I.R.C. §1411.
The real estate professional exception to the per se rule that rental activities are passive is an important one. The issue may occur quite often in agricultural settings. In the next post on Monday, we will dig a little further on the passive loss rules.