The US District Court, Western District of Arkansas, recently ruled in favor of a taxpayer who asserted real estate professional status in order to treat income from his rental real estate activities as non-passive. The taxpayer was an executive and part owner of a property management company which managed numerous real estate properties in which he owned an interest.
The Real Estate Professional Rule: An Overview
Income derived from the rental of real estate is deemed passive by nature, which limits the ability to deduct losses from the activity. For real estate professionals, however, rental real estate activities can qualify as non-passive, allowing for net losses to be deducted. A taxpayer is considered a real estate professional during a tax year if:
· More than 50% of the taxpayer’s time devoted to all businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates; and
· The taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.
Additionally, in order for the taxpayer’s hours to qualify for this test, they must own more than 5 percent of businesses for which they are performing the services.
Real property trades or businesses include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. Material participation requires a taxpayer to meet one of seven tests outlined in the IRS regulations, which can be found here.
For purposes of meeting the hours test necessary for consideration as a real estate professional, a taxpayer may elect to group several real estate activities together as one activity.
Facts of the Case
Roy Stanley was the president and 10 percent owner of a property management company (“PMC”) for which he performed legal services. Stanley had an ownership interest in over 100 real estate entities, which were managed by the PMC, and also owned several rental real estate properties individually. Stanley reported rental losses on his tax return as non-passive and asserted that he qualified as a real estate professional. Stanley’s tax return was audited, and the IRS auditor reclassified Stanley’s rental activities as passive losses, resulting in additional taxes due.
The Government argued that Stanley’s legal services did not qualify as an activity performed in a real property trade or business because legal services are not a real estate activity. The Court found, however, that the IRS regulations do not require that a taxpayer’s services be of a particular nature, nor do they need to be directly related to real estate. They simply need to be “performed in real property trades or businesses in which the taxpayer materially participates.” Stanley materially participated in the PMC, and the PMC is a real property trade or business.
The Government also argued that Stanley’s legal services and management services benefited the PMC as a whole and/or numerous properties managed by the PMC. These services, therefore, would not count towards the material participation requirements of the properties owned by Stanley because they were not directly related to those properties specifically. The Court disagreed with this argument as well. The Court’s findings stated that a taxpayer working for a large PMC of this nature would encounter legal and other issues on a large scale that would affect numerous properties, even properties in which the taxpayer had no ownership interest. The Court decided that management of a PMC would require a broad array of services, and Stanley’s services in such a capacity would qualify as material participation.
Traditionally, the IRS has ruled that in order to be considered a real estate professional, a taxpayer must perform services directly related to real estate. An example would be a taxpayer who owned a business for which they performed construction or real estate brokerage services. Someone who performed legal services would not have been thought to qualify as a real estate professional because legal services are not directly related to real estate. The ruling in the Stanley case, however, has now provided additional flexibility in determining real estate professional status. Taxpayers who own and perform services (regardless of the nature of the services) for companies in a real property trade or business should revisit their tax situation and determine how the Stanley ruling may impact them.
While this ruling is not binding in other district courts it can be cited as persuasive authority and gives taxpayers insight into how another court may rule on a similar fact pattern.
The Real Estate Professional rules are complex. It is recommended that you discuss your individual circumstances with your tax advisor. Please contact your W&G advisor for additional information or guidance about this article.