Sec. 469 defines a passive activity, in part, as:
- Any trade or business of the taxpayer in which the taxpayer does not materially participate, and 8
- Any rental activity of the taxpayer except as provided under Sec. 469(c)(7). 9
A taxpayer can overcome the presumption that all rental activities are passive if the taxpayer qualifies as a real estate professional by satisfying the two quantitative tests of Sec. 469(c)(7)(B):
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
It is a common misconception, however, that qualifying as a real estate professional makes the taxpayer's rental activities nonpassive. This is not the case; rather, a taxpayer who qualifies as a real estate professional has merely overcome the presumption that all rental activities are passive regardless of level of participation. For the real estate professional's rental activities to become nonpassive activities, the taxpayer must establish that he or she has met the material-participation standard with regard to the rental activities. Only those rental activities in which the real estate professional materially participates are nonpassive activities.
Importantly, the statute provides that a qualifying real estate professional must establish material participation in each separate rental activity. An exception is provided, however, by which the taxpayer may elect to aggregate all interests in rental real estate for purposes of measuring material participation.
Material Participation
- A trade or business activity isn’t a passive activity if you materially participated in the activity.
Material participation tests.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
- You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
You didn’t materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if:
- Any person other than you received compensation for managing the activity, or
- Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).
A taxpayer who passes both tests to be a qualifying real estate professional must next establish material participation in his or her rental activities.
- Does the taxpayer materially participate in each separate rental activity?
- Each rental activity in which a qualifying real estate professional materially participates is nonpassive. Any rental activity in which the taxpayer fails to materially participate, however, is passive despite the taxpayer's qualification as a real estate professional.13
- As an alternative, a qualifying real estate professional may elect to aggregate all of his or her rental activities for purposes of establishing material participation.
A qualifying real estate professional who intends to aggregate all rental activities must make a formal election; merely aggregating all of the taxpayer's rental activities into one column on Schedule E, Supplemental Income and Loss, of Form 1040, U.S. Individual Income Tax Return, does not satisfy this requirement.51 A qualifying real estate professional makes the election to aggregate all interests in rental real estate by filing a statement with the taxpayer's original income tax return for the tax year. This statement must contain a declaration that the taxpayer is a qualifying real estate professional for the tax year and is making the election pursuant to Sec. 469(c)(7)(A).
A taxpayer may revoke the election only in the tax year in which a material change in the taxpayer's facts and circumstances occurs or in a subsequent year in which the facts and circumstances remain materially changed from those in the tax year for which the election was made. To revoke the election, the taxpayer must file a statement with the taxpayer's original income tax return for the year of revocation. This statement must contain a declaration that the taxpayer is revoking the election under Sec. 469(c)(7)(A) and an explanation of the nature of the material change.52