Passive Loss Limitations Revisited: Getting on the Right Side of Material Participation

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Ericsson_Mark_webPrior to the passage of Section 469 in 1986, wealthy taxpayers could purchase tax shelters that would reduce their income to zero. The most obvious tax shelter was improved real property, which tax law had assigned a depreciation deduction to offset the impact of wear and tear on the improvements. This correctly led to the perception that the wealthy could buy that deduction as an investment and pay no taxes.

A taxpayer owning real property had always been allowed a deduction for depreciation allowing that deduction against ordinary income. This had become the opportunity to reduce one’s income to zero for those that could own enough real estate.

Congress focused on establishing the size of the depreciation deduction to provide a consistency in these deductions. These statutory limits in effect made the investment deductable. Of course, the economics of the time played into the setting of these deductions. Higher deductions led to lower taxes for those buying the real property, which led to a rising real estate market, and happy and stable voters.

Congress believed that the way to cure this problem was to disconnect the tax shelters from being an investment with a deduction attached. Congress created the concept that a taxpayer must participate in the activity which generates the loss. Expenses (real or statutorily created) associated with the activity could be written off against income from the activity. The concept turned on material participation.

If the taxpayer has skin in the game in the form of time involvement and management energy, the activity takes on a legitimate goal of producing an end product (real estate holdings, a business conducted through a pass-through entity).

Thus, Treasury went about trying to define what it took to materially participate in an activity. Unfortunately, the policy did not translate well. It was not widely disseminated that the material participation rules were intended to create activities resembling business endeavors and needed to be supported by business records.

The government has an almost insurmountable advantage in almost any argument over material participation because most of the determinative factors are based upon hours spent on the activity. The burden is on the taxpayer to prove that the number of hours has been satisfied.

In most cases, where passive loss rules come into play, the taxpayer has some passive loss activities that generate income and some passive activities that generate losses. The taxpayer is trying to match the two. Since pass-through entities where there is a lack of material participation are subject to the passive loss limitations, these must be evaluated to see which side of the line they fall. The levels of participation differ between fee simple real properly ownership and entity-owned properties.

Quickly, the tax professionals began to look for ways to take advantage of the rules. The most obvious were to recharacterize rents as non-passive income so the losses could be written off against ordinary income. Real estate professionals quickly convinced Congress that those truly in the business of real estate should be treated as in business and their losses should be treated as ordinary losses.

Tax professionals began to characterize two buckets of income as passive and active. Passive would be subject to the passive losses rules. Active would integrate into the tax preparation process under the ordinary income rules.

However, writing the rules to allocate these two classes of income has proved a mightier task than first imagined.

woman_holding_money-house_webThe rules involving exemption as a professional real estate operator seemed pretty straight forward. A person had to spend more than 750 hours and more than one-half of the time he spent in the real estate profession on his properties.

If the taxpayer was a developer, he had to spend more than one-half of his time managing his personal properties, to be treated in the business of real estate with respect to the ownership of his properties. Issues arise as to what constitutes participation in real estate professions (mortgage brokerage?). Once the taxpayer qualifies as a real estate professional, he must prove that he materially participated in each activity that he wants to be able to deduct net losses from ordinary income.

To prove material participation, the taxpayer must meet one of seven mathematical tests at Treas. Reg. §1.469-5T. The tests consider the number of hours spent on the activity, the proportion to which the taxpayer participated in the activity compared to other individuals, the amount of activity spent on the activity over a number of years, and/or facts and circumstances that tend to show that the amount of participation in the activity by the taxpayer was substantial.

Disallowed passive losses are carried forward, and upon disposition of the activity, are released and allowed to be deducted against ordinary income. As a real estate operator, a taxpayer can elect to treat all activities as one activity for meeting any of the tests above. For some reason, it is widely believed that this grouping does not allow the taxpayer to realize disallowed loss carry forwards to be released and deducted against ordinary income.

Treasury Regulation §1.469-2T(d)(5)(i) and (ii) provides that a loss from a disposition of an activity is treated the same as a deduction from such activity and is subject to the passive loss rules. A total distribution would trigger a loss and would be allowed where the taxpayers are estate professionals and can recognize rental real estate losses, contrary to most practitioners’ understanding of the law and reporting practices.

The rules have an unexpected impact on general liability practices. The taxpayer has to keep an eye on the nature of title holding. If the real property is sitting in a limited liability company or other income pass-through entity, the taxpayer must prove a higher level of participation, namely compliance with hours of participation in that LLC that meets the standards of 1, 5 or 6 above. This may dramatically change the entity structure preferred by the taxpayer. Many taxpayers never discover this dichotomy until audit or appeals.

Often, the taxpayer has a large passive loss available to write off against passive income. The regulations leave a huge hole for structuring in this area. Let’s say the taxpayers own a mortgage broker/bank passing through its income as an S Corporation which has contributed to the real estate holdings. Taxpayers work full time in the bank and would seem to be well over the threshold, making this an active activity against which the passive real estate losses cannot be written off.

However, Treasury Regulation §1.469-5T(b)(2)(ii) provides that an individual’s services performed in the management of an activity shall be taken into account in determining whether the individual is treated as materially participating in such activity for the taxable year … unless, for such taxable year:

  • (a) No person (other than the individual) who performs services in connection with the management of the activity receives [earned income] in consideration for such services, and
  • (b) No individual performs service in connection with the management of the activity that exceed (by hours) the amount of such services performed by such individual.

This was to prevent taxpayers to convert active activities to passive activities by allowing the taxpayer to claim minimal participation by hiring others to manage the activity. Now, to move the income generator over to the passive category, one needs merely to hire managers. This resulted in a tax decrease of $2.7 million in a recent audit.


Mark Ericsson is a partner in the tax and business firm of Youngman & Ericsson. Mark has written over 30 articles on tax and business issues.
mericsson@youngman.com | (925) 930-6000 | http://www.youngman.com/attorney_mericsson.html

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