By Alan Zgoda
For Real Estate Professionals (REPs), two of the most important questions asked for tax purposes are, “Did I materially participate?” and “Is this a rental activity or not?” For better or worse, the answers to these questions can completely change how you are treated for tax purposes.
In 2019, two court cases illustrated both the importance of asking these questions and of consulting with a professional when dealing with complex tax issues: Barbara v. Commissioner (Docket No. 27804-16 T.C. Memo 2019-50) and Eger v. United States (405 F. Supp. 3d 850 (N.D. Cal.).
Before we dip into the minutia of these cases, it is important to know what it means to be considered an REP and when an activity is considered a rental activity. A taxpayer is considered an REP if they:
- spend more than one-half of their personal services during the tax year in real property trades or businesses (50-percent rule)
- materially participate, and
- spend more than 750-hours in those services
Being considered an REP under the internal revenue code means that rental activities are no longer considered to be passive income generators, and therefore they produce non-passive income and losses. Unlike passive losses, non-passive losses can be used to offset other types of income, thereby bestowing a massive tax benefit, whereas passive losses can only offset other passive income. However, even if the taxpayer is an REP under the tax code, the activity must be considered a rental activity to reap the benefits of their title.
Is it considered a “rental activity?”
In Eger v. United States, the main issue was whether or not the taxpayer’s activities were considered “rental activities.” The court’s initial opinion was that Greg Eger clearly met all the requirements of an REP. The Egers owned three separate properties, each of which were leased out to three separate management companies and then subleased to customers. However, the Egers decided to retain the right to use the properties.
To be considered a rental activity, the average period of a customer or management company having a “continuous or recurring” right to use a property must be more than seven days. The Egers did not even use two of the three properties during the tax year, but they retained the right to use them. This meant that the average period of continuous or recurring use was now based on the customers’ use, instead of the management companies, according to the court.
This seemingly minor detail tipped the scales out of favor for the Egers, because the customers’ average use of the properties was seven days or less, and so it removed the label of rental activity from all three properties. Even though Greg Eger was an REP, the properties were no longer rental activities. This meant that all of his losses from the properties were now considered passive, and could only be deducted against other passive income.
The Egers’ defense to the issue at hand was based on two court cases, White v. C.I.R. and Hairston v. C.I.R., two separate cases involving the lease and sublease of real property. In both cases, the courts found that it was okay for the average period of continuous or recurring right to use to be based on the management company and not the customers, for the sole reason that the taxpayers in each case did not retain the right to use the properties for their selves.
Material Participation & the 50-Percent Rule
Even if a taxpayer does not retain the right to use their properties, the concept of material participation still comes into play. Material participation can play a role in a number of tax rules and regulations, not the least of which is rental activities. The standard concept is that a taxpayer materially participates when they are active in a business on a regular, continuous, and substantial basis during the year (amongst other rules discussed later in this article).
To even be considered a REP, a taxpayer must materially participate in their real property trade or business in addition to meeting the 750-hours and 50-percent rule. Not materially participating could mean the difference between being able to deduct all your losses on a bad year and effectively hiding other income from taxation, or being restricted to deducting your losses against only passive income. Some passive income, such as long-term capital gains and qualified dividends already have highly favorable tax rates, further adding to the loss of benefit.
Despite being a very brief, seemingly uninteresting case, Barbara v. Commissioner illustrates a very odd decision by the courts regarding material participation. For a taxpayer to materially participate in an activity, they must meet one of seven rules per the internal revenue code. The first being that the taxpayer participates in the activity for more than 500-hours during the year. This rule is the most straight-forward and leaves little for the imagination. However, the final and seventh rule is based on “facts and circumstances” and 100-hours of participation. The seventh rule should be a matter of last resort, where the taxpayer would essentially have to plead their case to the court as to why they actually materially participated.
In Barbara v. Commissioner, the courts had calculated that Fred Barbara spent not just 500-hours, but a total of 700-hours in his money-lending business. Instead of deciding that the first test was met and case closed, the courts focused on the seventh test, and whether the taxpayer’s participation was “regular, continuous, and substantial” as a matter of facts and circumstances.
The fact that the Barbaras were ruled to have materially participated based on the seventh rule can potentially set a beneficial precedent for future cases. Even outside of the real estate field, if a taxpayer was able to materially participate in a business by virtue of only 100-hours, it could potentially open up many more opportunities to get non-passive income and more easily deductible losses.