IRS Releases Guidance on Applying PAL Rule
The IRS has provided guidance on applying the passive activity loss (PAL) rules to a taxpayer who may be a real estate professional. The IRS concluded that a taxpayer's status as a real estate professional depends on the taxpayer's participation in all real property trades or businesses. However, the real estate professional still must materially participate in an individual activity to avoid PAL treatment of losses from the activity.
Per se rule
Ordinarily, rental activities, including rental real estate, are a per se passive activity under Code Sec. 469. If an activity is passive, losses from the activity are treated as PALs and cannot be deducted against nonpassive income, such as compensation.
Real estate professionals
There is an exception from the per se rule for a real estate professional who "performs" enough hours in all real estate trades or businesses and who "materially participates" in the particular activity. The exception requires that the taxpayer:
- Perform more than one-half of his or her personal services in real property trades or businesses in which the taxpayer materially participates; and
- Performs more than 750 hours of services in real property trades or businesses in which the taxpayer materially participates.
A taxpayer materially participates in an activity if he or she participates in the activity for more than 500 hours during the year. This 500-hour threshold has to be met separately for each individual activity.
Combined Real Property Business
The IRS looked at a taxpayer who owned two rental real estate properties and who also owned a real property development business. The taxpayer performed more than 750 total hours of personal services in all of the real estate activities.
The rentals and the development business were a combined real property trade or business. The question arose whether the 750-hour performance test could only apply to an individual activity (such as the separate real estate rental properties) that met the 500-hour material participation test.
The IRS concluded that this was not necessary. Since the taxpayer spent more than 500 hours in this combined real property business, time spent in each of these activities (the rentals and the property development) could be counted toward the 750-hour test. Thus, the taxpayer satisfied the requirements for being a real estate professional.
However, the two rental properties were separate activities. Before the taxpayer could deduct losses from either rental activity, it was necessary to determine whether the taxpayer materially participated in the individual activity. An activity is passive unless the taxpayer satisfies the 500-hour test for that activity, even if the taxpayer is a real estate professional.
For more information, please contact your Brown Smith Wallace Tax Advisor, or Cathy Goldsticker, at 314.983.1274 or firstname.lastname@example.org.