Prior to the enactment in 1986 of the passive activity loss rules, many lawyers, doctors, and other high-income individuals would invest in tax shelters that generated tax losses, which could be used to offset their other income. The passive activity loss rules now prevent taxpayers, including trusts, from deducting their losses from certain “passive” activities against that taxpayer’s active income (such as wages) or portfolio income (such as interest and dividends). For an individual to have active income or losses from a rental real estate business, the individual must generally be a “real estate professional” who works full-time in the real estate business. For trusts, the passive activity loss rules have historically been confused and contradictory. In the recent case of Frank Aragona Trust v. Commissioner, 142 T.C. No. 9 (2014), the Tax Court concluded that a trust could qualify as a “real estate professional” due to the activities of three trustees. The trust was therefore allowed to use its losses from the real estate activities against income from its investments and other activities.
Material Participation
The Internal Revenue Code contains detailed passive activity loss rules for individuals. A trade or business activity is considered non-passive for a taxable year only if the individual materially participates in the activity, such as by spending more than 500 hours on the activity during the year. However, nearly all rental real estate activities are considered per se passive activities, regardless of the taxpayer’s level of involvement, unless the taxpayer can prove that he is a “real estate professional.” A “real estate professional” must generally (i) spend more than 750 hours during the year in real property trades or businesses in which he materially participates, and (ii) those hours must constitute more than half of his time spent performing all personal services that year. Real property trades or businesses include real property construction, condominium development, property brokerage, apartment leasing, and hotel management. An individual taxpayer must spend all of the 750 hours personally, and cannot count the hours spent by his spouse toward the total hours. Once a taxpayer is a real estate professional, if he or his spouse materially participates in a real estate rental activity, it will generate non-passive income and losses.
