The following “Expertise Beyond the Numbers” blog post provides insights from SC&H Group’s Tax Services team on the per se passive rule under the tax code as it pertains to rental activity.
By rule, all rental activity is per se passive under the tax code. The per se passive rule does not apply, however, to any rental real estate activity of a taxpayer for a taxable year if the taxpayer can show that they are a Qualified Real Estate Professional.
To qualify as a Real Estate Professional, a taxpayer must pass both of the following test:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates.
- Taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which he or she materially participates.
For purposes of the Real Estate Professional’s exception to the Passive Activity Loss (PAL) rules, personal services performed as an employee can only count as real property trade or business hours if the employee is a greater-than-5-percent owner of the employer. If the employer operates as a corporation, this is 5 percent of the outstanding stock of the company.
If the employer is not a corporation, this greater-than-5-percent requirement can apply to either a capital or profits ownership. For many participants in the real estate industry, this is the most difficult hurdle to overcome as it is very common for an individual to own a piece of a particular project and still receive a salary from an employer in which he or she is not an owner.
A recent ruling in the case of Stanley v. U.S., 116 AFTR 2d 2015-XXXX (DC AR) affirms these rules.
In this case, the taxpayer used hours worked as an employee in a company which he was a greater-than-5-percent owner to fulfill the requirement for the real estate professional’s exception. The Internal Revenue Service argued that the taxpayer was not a greater-than-5-percent owner because his ownership in the employer stock was restricted. The District Court disagreed, and asserted that despite the restriction on the stock, the fact that the taxpayer owned a more-than-5-percent interest in the company was indisputable. Accordingly, the District Court deemed that the taxpayer had materially participated in his aggregated rental activity, and appropriately grouped his business activities with his rental activities as a single PAL activity on Schedule E.
It is very common to find employees who work for a real estate firm and also own and operate rental properties. While they are spending significant time in a real estate trade or business, the hours spent as an employee do not count toward meeting the above tests unless they also own more than 5 percent of the employer.
Unfortunately, the clear-cut solution of acquiring 5 percent of employer-company may not be a viable option. Other options, which might provide a reasonable position, include employee payroll sharing agreements between the employer company and rental properties where the taxpayer owns a more than 5 percent interest in, and the use of stock restrictions, if an ownership interests in the employer company is awarded.
If you would to like learn more about the Real Estate Professional requirements and the impact these rules have on your ability to deduct losses related to your real estate holdings, please contact Justin Huovinen or Stephen Bishop at SC&H Group.