Several abusive tax shelters in the 1970s and 1980s caused Congress to enact rules to prevent taxpayers from deducting losses when a taxpayer doesn’t materially participate in the activity. These passive loss rules apply to individuals (including partners and S Corp shareholders), trusts, estates, personal service corporations and sometimes closely held corporations. In short, these rules are a wide net that catches a lot of businesses and can impact a lot of taxpayers. If an activity is determined to be a passive activity it may not only effect the losses claimed but could trigger a 3.8 percent increase from the net investment income tax. Knowing the passive activity rules, and how they apply, can help avoid a dispute or streamline arguments if the IRS questions business activities.
Activities Covered by the Rules
The passive activity rules, contained in Section 469 of the Internal Revenue Code, apply on an activity-by-activity basis. Passive activities are, in general, trade or business activities where a taxpayer does not materially participate or rental activities that are usually presumed to be passive. The courts have held that there are two basic requirements for an activity to be considered a trade or business activity. First, the activity must be conducted for a profit and, second, it must be done regularly and continuously. Some activities require closer scrutiny, such as businesses that trade securities or other property (including cryptocurrencies which are treated as property – IRS Notice 2014-21). If the company merely invests, as opposed to actively turning over the investment portfolio through regular trading, then it might be considered passive activity. Rental activities are considered passive activities, regardless of material participation unless exceptions outlined in the regulations are met. See Treas. Reg. §1.469-1T(e)(3).
Real Estate Professional Exception
Section 469(c)(7) exempts “real estate professionals” from the per se passive rule for rental activities. This doesn’t automatically make the activities non-passive, because the taxpayer must still meet the material participation requirements and this is where most disputes arise. To qualify as a real estate professional exemption, half of the taxpayer’s trade or business activities and at least 750 hours must be performed in the real property trades or businesses. This means activity in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Documentation of the type and amount of activity is key to meeting these rules and ambiguities will work to deny qualification by both the IRS and the courts. The most useful evidence are calendars, daily logs, journals or other documentation clearly identifying both the type of activities and the time spent. If a taxpayer is otherwise employed full time, then the IRS is likely to question whether the exception applies. Shift work (e.g. three day shifts of twelve hours) or efficient use of evenings and weekends can still meet the hourly requirements, if properly documented. Most cases are lost on lack of documentation, especially if assumptions of a lack of sufficient time seems reasonable.
What is Material Participation?
In general, a taxpayer materially participates in an activity only if the participation is regular, continuous and substantial. Each of those terms is subject to interpretation and are covered in extensive regulations by the IRS. See Treas. Reg. §1.469-5T. The IRS regulations contain a series of specific tests and a catchall test if “based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis.” See Treas. Reg. §1.469-5T(a)(7). Taxpayers must be careful with certain activities that are related to their role as an investor. Certain activities involving studying or reviewing financial statements, preparing analysis of finances or operations, or monitoring finances or operations will not be material participation unless the taxpayer is directly involved in management and operations. Compare Lapid v. Comm’r, TC Memo 2004-222 (denying material participation) with Lamas v. Comm’r, TC Memo 2015-59 (accepting material participation). This material participation requirement, however, works both ways (i.e. both income and loss) so a failure to materially participate for income purposes may increase the amounts of income that can be offset by failure to materially participate for loss purposes. Therefore, all activities and the income and losses they generate must be evaluated.
Nobody likes surprises, especially when it comes to taxes. Unfortunately, the passive activity rules are a frequent cause of IRS adjustments for taxpayers unaware that it applies to their real estate or other investments. Understanding these rules can help individuals and businesses prepare and plan for potential disputes. If you find yourself on the receiving end of an IRS adjustment you believe is improper, a tax lawyer can help you marshal the proper evidence and defend your position at the IRS or in court.