Real Estate Professionals and Aggregation – The Passive Loss Rules

Overview

Last April I devoted a post to the general grouping rules under I.R.C. §469.  https://lawprofessors.typepad.com/agriculturallaw/2018/04/passive-activities-and-grouping.html   Those rules allow the grouping of passive investment activities with other activities in which the taxpayer materially participates.   Thus, for example, an investor in an ethanol plant might be able to group the losses from that investment with the taxpayer’s farming activity. Grouping may make it more likely that the taxpayer can avoid the passive loss rules and fully deduct any resulting losses.

But, there’s another grouping rule – one that applies to a taxpayer that has satisfied the tests to be a real estate professional and it’s only for purposes of determining material participation in rental activities.  This election is an all-or-nothing election – either all of the taxpayer’s rental activities are aggregated or none of them are. 

The aggregation election for real estate professionals – that’s the focus of today’s post.

Real Estate Professional

In last Thursday’s post, https://lawprofessors.typepad.com/agriculturallaw/2019/03/passive-losses-and-real-estate-professionals.html  I detailed the rules under I.R.C. §469 pertaining to a real estate professional.  To qualify as a “real estate professional” two test must be satisfied:  (1) more than 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).Another way of putting is that once the tests of I.R.C. §469(c)(7) are satisfied it doesn’t necessarily mean that rental losses are non-passive and deductible, it just means that the rental losses aren’t per se as passive under I.R.C. §469(c)(2).  See, e.g., Gragg v. United States, 831 F.3d 1189 (9th Cir. 2016); Perez v. Comr., T.C. Memo. 2010-232.  An additional step remains – the taxpayer must materially participate in each separate rental activity (if there are multiple activities). 

Note:  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.  In addition, when a joint return is filed, the requirements to qualify as a real estate professional are satisfied if either spouse separately satisfies the requirements.  I.R.C. §469(c)(7)(B). 

Is Separate Really the Rule?

As noted above, if a taxpayer has multiple rental activities, the taxpayer must materially participate in each activity.  That can be a rather harsh rule.  But, there is an exception.  Actually, there are two.  If material participation test cannot be satisfied, the taxpayer can use a relaxed rule of active participation.  I.R.C. §469(i).  That rule allows the deduction of up to $25,000 of losses (subject to an income phase-out).  In addition, the taxpayer can make an election to aggregate all of the rental activities that the taxpayer is involved in for purposes of meeting the material participation test.  Treas. Reg. §1.469-9(g)(1).  This aggregation election is available to a taxpayer that has satisfied the requirements to be a qualified real estate professional under I.R.C. §469(c)(7).  See, e.g., C.C.A. 201427016 (Jul 3, 2014).

Points on aggregation.  Aggregation only applies to the taxpayer’s rental activities.  Activities that aren’t rental activities can’t be grouped with rental activities. In addition, it’s only for purposes of determining whether the material participation test has been met.  Because the election only applies to rental activities, time spent on non-rental activities won’t help the taxpayer meet the material participation test for the rental activities.  This makes the definition of a “rental activity” important.  I highlighted the designated rental activities in last Thursday’s post.  One of them is that the real estate must be used in a rental activity rather be realty that is held in the taxpayer’s trade or business where the average period of customer use for the property is seven days or less.  Temp. Treas. Reg. §1.469-1T(e)(3)(ii); see also Bailey v. Comr., T.C. Memo. 2001-296.   

By election only.  Aggregation is accomplished only by election.  Treas. Reg. §1.469-9(g)(3).  It’s not enough to simply list all of the rental activities of the taxpayer in a single column on Schedule E.  In Kosonen v. Comr., T.C. Memo. 2000-107, the petitioner owned seven residential rental properties.  As of the beginning of 1994, he had non-deductible suspended losses of $215,860 from his properties.  He put in almost 1,000 hours in rental activities in each of 1994 and 1995.  On this 1994 return, he listed each rental property and loss separately on Schedule E and reported a combined loss of $56,954 on line 42 of Schedule E – the line where a taxpayer that is materially participating in rental activities reports net income or loss from all rental activities.  He also reported the loss on line 17 of Form 1040 and subtracted it from other income to compute his adjusted gross income.  He also filed Form 8582 to report the $56,954 loss.  However, he didn’t attach an aggregation statement to the return noting that he was electing to treat his rental real estate activities as a single activity.  He also didn’t combine his 1994 Schedule E rental real estate losses with his previously suspended losses.  The IRS noted that had a proper election been made that the petitioner would have satisfied the material participation requirement.  But, the IRS took the position that an election had not been made and as a result the material participation requirement had to be satisfied with respect to each separate activity.  Because he could meet the material participation test in any single activity by itself, the IRS asserted, the resulting losses were suspended and couldn’t offset active income.  The Tax Court agreed with the IRS.  While the form of his entries on the return were consistent with an aggregation election, the Tax Court held that his method of reporting net losses as active income was not clear notice of an aggregation election.  The fact that the IRS had not yet issued guidance on how to make an aggregation election didn’t eliminate the statutory requirement to aggregate, the Tax Court concluded.     

Attached statement.  To satisfy the statutory election requirement, the election statement attached to the return should clearly state that an election to aggregate rental activities is being made via I.R.C. §469(c)(7)(A) and that the taxpayer is a qualifying taxpayer in accordance with I.R.C. §469(c)(7)(B).   

Late election relief.  It is possible to make a late election via an amended return.  In Rev. Proc. 2011-34, 2011-24 I.R.B. 875, the IRS said a late election can be made in situations where the taxpayer has filed returns that are consistent with having made the election.  In that event, the late election applies to all tax years for which the taxpayer is seeking relief.  The late election is made by making the election in the proper manner as indicated above as an attachment to the amended return for the current tax year.  The attachment must identify the tax year(s) for which the late election is to apply, and explain why a timely election wasn’t initially made.  The opportunity to make a late election is important.  See, e.g., Estate of Ramirez, et al. v. Comr., T.C. Memo. 2018-196. 

Binding election.  The aggregation election cannot be revoked once it is made – it is binding for the tax year in which it is made and for all future years in which the taxpayer is a qualifying real estate professional.  If intervening years exist in which the taxpayer was not a qualified real estate professional, the election has no effect in those years and the taxpayer’s activities will be evaluated under the general grouping rule of Treas. Reg. §1.469-4.  Treas. Reg. §1.469-9(g)(1). 

Years applicable.  If the election hasn’t been made in a year during which the taxpayer was a qualified real estate professional, it can still be made in a later year.  But, the election is of no effect if it is made in a year that the taxpayer doesn’t satisfy the requirements to be a real estate professional.  Treas. Reg. §1.469-9(g)(1).  In other words, the election may be made in any year in which the taxpayer is a qualifying taxpayer for any tax year in which the taxpayer is a qualifying taxpayer. In addition, the failure to make the election in one year doesn't bar the taxpayer from making the election in a later year.  Treas. Regs. §§1.469-9(g)(1) and (3).  

Revocation.  While the aggregation election is normally binding, the aggregation election can be revoked for a year during which the taxpayer’s facts and circumstances change in a material way.  If that happens, the election can be revoked by filing a statement with the original tax return for that year.  According to the regulations, the statement must provide that the I.R.C. §469(c)(7)(A) election is being revoked and describe the material change in the taxpayer’s factual situation that justifies the revocation.  Treas. Reg. §1.469-9(g)(3). 

Rental real estate activities held in limited partnerships.  What happens if the taxpayer makes the election to aggregate all real estate rental activities but not all of the taxpayer’s interests in real estate activities are held individually by the taxpayer?  The regulations address this possibility and use an example of an interest in a rental real estate activity held by the taxpayer as a limited partnership interest.  Treas. Reg. §1.469-9(f)(1). The result is that the effect of the aggregation election doesn’t necessarily apply in this situation.   Instead, the taxpayer’s combined rental activities are deemed to be a limited partnership interest when determining material participation and the taxpayer must establish material participation under one of the tests that apply to determine the material participation of a limited partner contained in Treas. Reg. 1.469-5T(e)(2).  Treas. Reg. §1.469-9(f)(1). But, there is a de minimis exception that applies if the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of the taxpayer’s share of gross rental income from all of the taxpayer’s interests in rental real estate for the tax year.  In this situation, the taxpayer can determine material participation by using any of the tests for material participation in Treas. Reg. §1.469-5T(a) that apply to rental real estate activities.  Treas. Reg. §1.469-9(f)(2).  This is also the rule if the taxpayer has an interest in a rental real estate activity via an LLC.  An LLC interest is not treated as a limited partnership interest for this purpose.  Thus, the taxpayer can use any of the seven tests for material participation contained in Treas. Reg. §1.469-5T(a).  See, e.g., Garnett v. Comr., 132 T.C. 368 (2009); Hegarty v. Comr., T.C. Sum. Op. 2009-153; Newell v. Comr., T.C. Memo. 2010-23; Thompson v. Comr., 87 Fed. Cl. 728 (2009), acq. in result only, A.O.D. 2010-002 (Apr. 5, 2010); Chambers v. Comr., T.C. Sum. Op. 2012-91. 

It should be noted that in its 2017-2018 Priority Guidance Plan, the IRS stated that it planned to finalize regulations under I.R.C. §469(h)(2).  That provision creates a per se rule of non-material participation for limited partner interests in a limited partnership unless the Treasury specifies differently in regulations.  Those regulations were initially issued in temporary form and became proposed regulations in 2011.  Until the IRS takes action to effectively overturn the Tax Court decisions via regulation, the issue will boil down (as it has in the Tax Court cases referenced above) to an analysis of a particular state’s LLC statute and whether there are sufficient factors under the state statute that distinguish an LLC from a limited partnership.

Effect on losses.  The aggregation election also impacts the handling of losses.  Once the aggregation election is made, prior year disallowed passive losses from any of the aggregated real estate rental activities can be used to offset current net income from the aggregated activities regardless of which activity produces the income or prior year loss.  At least this is the position take in the preamble to the regulations.  See Preamble to T.D. 8645 (Dec. 21, 1995).  This is the result even if the disallowed prior year losses occurred in tax years before the aggregation election was made.  Treas. Reg. §1.469-9(e)(4).   

Any suspended losses remain suspended until substantially all of the combined activities (by virtue of the election) are disposed of in a fully taxable transaction. This would be an issue if a rental real estate activity with a suspended loss is aggregated with other rental real estate activities.  Those suspended losses would not be deductible until the entire aggregated activity (now treated as a single activity) is disposed of.  Thus, depending on the amount of the suspended losses at issue, it may not be a good idea to make the aggregation election in this situation.  Likewise, it also may not be a good idea to make the aggregation election if the taxpayer has positive net income from rental real estate activities and passive losses from activities other than rental real estate activities.  If the election is made in this situation, the rental activities won’t be passive, and the taxpayer won’t be able to use the losses from the other passive activities to offset the income from the rental real estate activities.  The losses could then end up being suspended and non-deductible until the entire (combined) activity is disposed of. 

Conclusion

The aggregation election is an election that is available only for real estate professionals and can make satisfying the material participation test easier.  That can allow for full deductibility of losses from rental real estate activities.  But, the terrain is rocky.  Good tax advice and planning is essential.