How to qualify as a real estate professional:
1. First, you must materially participate (see below) in a real estate business. The business of
renting and leasing realty is a real estate business.
2. Second, more than 50% of the personal services you perform in all businesses during the year
must be performed in real estate businesses in which you materially participate.
3. Third, your personal services in material participation real property businesses during the year
must amount to more than 750 hours. For these purposes, you can’t count any work you
perform in your capacity as an investor.
In determining whether you qualify as a real estate professional, each of your rental real estate
interests is treated as a separate activity—that is, as a separate business—unless you make an
election to treat all those interests as a single activity.
Because of this rule, if you have multiple rental properties and you don’t make the election, you must
establish material participation for each property separately, and must satisfy the more-than- 50%
test and the 750-hours test for each property separately in order to qualify as a real estate
professional with respect to that property—and qualifying for one property wouldn’t mean you qualify
for any other property. Thus, if you don’t make the election, qualifying as a real estate professional
for all your properties becomes more difficult (and may become impossible) as the number of
properties increases. But if you do make the election, you only have to establish material
participation, and satisfy the more-than- 50% test and the 750-hours test, for the combined properties
as a whole.
You don’t have to work full-time in real estate to qualify as a real estate professional. Even if you
have another occupation, you can qualify if you materially participate in a real estate business, and
spend more time, and more than 750 hours, on that business. (But remember, in this case, if you
have multiple properties, it may be difficult or impossible to qualify unless you make the “single
interest” election mentioned above.)
These tests are applied annually. This means that you may qualify as a real estate professional in
some years but not in other years. As a result, the same real estate activity may generate passive
losses in some years and non-passive losses in other years.
If you’re a real estate professional, what more do you have to do to treat losses from
rental real estate as non-passive?
If you qualify as a real estate professional, your rental real estate properties are not automatically
treated as passive. This doesn’t mean that they are automatically treated as non-passive—it means
that, if you materially participate (as explained below) in the operation of a rental real estate
property, then it will be treated as non-passive, and you may deduct losses from that property
against other non-passive income.
But if the real estate business that qualifies you as a real estate professional is the renting or leasing
of real property, as discussed above, you will already have established that you materially participate
in that business—because if you don’t, you can’t qualify as a real estate professional on the basis of
that business (see above).
If you have multiple properties, you may not be able to qualify as a real estate professional unless
you elect to treat all your rental real estate interests as a single activity. If you make the election, it
applies both for purposes of qualifying you as a real estate professional, and for all other purposes of
the Passive activity rules. And, generally speaking, the election is irrevocable. This means that you
can’t make the election in order to qualify as a real estate professional, and then revoke it with
respect to a particular property later, when, for example, that property produces income, and you’d
like to use that income to absorb losses from another non-real- estate-related passive activity.
Making the election will also disqualify you from utilizing the $25,000 active participation rule
mentioned above, because that rule applies only with respect to losses from rental real estate
activities that are passive, and the election will—presumably—work to make your rental real estate
properties non-passive. (If making the election is the right course for you, I can make sure that it is
made in a timely and proper fashion.)
What’s material participation in an activity?
Material participation in an activity means involvement in the operations of the activity on a regular,
continuous, and substantial basis. If a taxpayer passes one of the following seven tests, IRS accepts
that as establishing material participation in an activity:
o participating in the activity for more than 500 hours in the tax year (the most frequently utilized
test);
o participating in the activity if the taxpayer’s participation is substantially all of the participation in
that activity by any individuals (including non-owners);
o participating in the activity for more than 100 hours in the tax year, if nobody else (including non-
owners) participated more;
o participating significantly in the activity, if participation in all “significant participation” activities
for the tax year exceeds 500 hours (but this test isn’t accepted for showing material participation
in rental activities);
o having materially participated in the activity during any five of the ten tax years before the year
at issue;
o with respect to personal service activities, having materially participated in the activity for any
three years (not necessarily consecutive) before the year at issue;
o showing regular, continuous and substantial participation on the basis of all the relevant facts
and circumstances, but only if more than 100 hours of participation during the tax year can be
shown (and management services aren’t taken into account for purposes of this test unless
certain stringent requirements are satisfied).
The extent of an individual’s material participation in an activity may be established by any
reasonable means. But the most reliable means of showing material participation consists of
contemporaneously kept appointment books, calendars, daily time reports, logs, or similar
documents that provide a detailed account of what the taxpayer did with respect to an activity, when
he or she did it, and how much time it took. Failure to substantiate material participation is one of the
most common ways of losing the right to treat rental real estate activities as non-passive.
Real estate professionals allowed late election to aggregate rental real estate interests.
The IRS has provided guidance that allows certain real estate professionals to make a late election
under the regulations to treat all interests in rental real estate as a single rental real estate activity for
purposes of the passive activity loss (PAL) rules. This election can make it easier to currently deduct
losses from real estate activities. As a general rule, the election is made by filing a statement with
the taxpayer’s original income tax return for the tax year. However, under new guidance, a
taxpayer meeting certain conditions can make a late election on an amended return.