Passive loss relief for real estate professionals: fact or fiction?

The Revenue Reconciliation Act of 1993 (RRA) amended Sec. 469(c) to remove the "per se" passive taint on rental real estate for taxpayers actively engaged in real property businesses. New Sec. 469(c)(7) allows real estate professionals who meet specified thresholds to determine if their rental real estate activities are passive or active under existing regulations.

These regulations, which define activities and material participation, were proposed before 1993 and do not consider the RRA's special treatment for real estate professionals. The implementation of this new law through those regulations, coupled with recent unofficial and informal - but public - comments by Treasury personnel, may severely limit the legislative relief intended by Congress.

Existing regulations: activities

defined

An activity's identification is important because:

* Within an activity, gains and losses may be netted, regardless of whether the transaction giving rise to the gain or loss is passive or active.

* Material participation must be determined for each identified activity.

Prop. Regs. Sec. 1.469-4 indicates that a taxpayer may use any reasonable method to group or segregate activities. However, because of the special "per se" passive treatment of rental activities, certain disaggregation rules apply:

* Rental activities generally may not be grouped with a trade or business activity (Prop. Regs. Sec. 1.469-4(d)).

* Personal property and real property rentals generally may not be grouped (Prop. Regs. Sec. 1.469-4(e)).

* Limited partners and limited entrepreneurs generally may not group an activity described in Sec. 465(c)(1) (related to at-risk activities) with other activities (Prop. Regs. Sec. 1.469-4(f)).

Activities not specifically disaggregated are grouped based on whether they represent an appropriate economic unit (Prop. Regs. Sec. 1.469-4(c)(1) and (2)). Factors to consider include:

* Similarities and differences in types of business.

* Extent of common control.

* Extent of common ownership.

* Geographical location.

* interdependencies between the activities.

These regulations are proposed to be effective for tax years ending after May 10, 1992.

Existing regulations: material

participation

Temp. Regs. Sec. 1.469-5T requires a taxpayer to meet one of seven tests for material participation:

1. More than 500 hours of participation (Temp. Regs. Sec. 1.469-5T(a)(1)).

2. Substantially all participation in the activity is by the taxpayer (Temp. Regs. Sec. 1.469-5T(a)(2)).

3. Participation for more than 100 hours and which exceeds any other individual's participation (Temp. Regs. Sec. 1.469-5T(a)(3)).

4. "Significant" participation activities (Temp. Regs. Sec. 1.469-5T(a)(4)).

5. Material participation in five of the last 10 tax years (Temp. Regs. Sec. 1.469-5T(a)(5)).

6. Material participation in a personal service activity for any three prior years (Temp. Regs. Sec. 1.469-5T(a)(6)).

7. Regular, continuous and substantial participation under the facts and circumstances (Temp. Regs. Sec. 1.469-5T(a)(7)).

Generally, a limited partner is treated as not materially participating in activities conducted by a partnership (Sec. 469(h)(2)). However, Temp. Regs. Sec. 1.469-5T(e)(2) provides three exceptions - tests 1, 5 and 6 above. In addition, a limited partner who at all times during the tax year also holds a general partner interest in the same partnership is not treated as a limited partner (Temp. Regs. Sec. 1.469-5T(e)(3)(ii)).

The RRA: eligible taxpayers

Sec. 469(c)(7)(b) defines taxpayers excluded from the "per se" passive taint for rental real estate - the so-called "super material participation" rules. During a tax year, more than one-half of a taxpayer's personal services performed in trades or businesses must be in real property trades or businesses and the real property trade or business personal services hours must exceed 750 hours. Only those real property trades or businesses in which the taxpayer materially participates are considered for these tests.

The RRA: special activity

aggregation rules

Under Sec. 469(c)(7)(A)(ii), taxpayers eligible to categorize their rental real estate activities as active or passive under the temporary and proposed regulations generally must treat each interest in rental real estate as a separate activity. However, the taxpayer may elect to treat all interests in rental real estate as one activity.

This election overrides the proposed regulations, which would require the taxpayer to demonstrate that separate interests could be grouped as an appropriate economic unit through some economic ties, such as ownership, control or integrated services.

The RRA: the interpretive 

problem

Sec. 469(c)(7)(A) concludes with the following sentence:

Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

Treasury personnel have unofficially and informally, but publicly, indicated several possible interpretations of this last sentence:

* If the election results in aggregation of ownership interests that include a limited partner interest, the aggregated activity must be tested for material participation under the special limited partner rules.

* General partner and other interests must be disaggregated from a limited partner interest. In other words, the election does not apply to limited partner interests.

* The election allows aggregation of all interests for purposes of determining taxpayers eligible for the super material participation rules, but not the material participation rules for identifying an activity as passive or active.

Proposed regulations:

the application problem

Segregation of rental real estate from trade or business activities was included in the proposed regulations to further the "per se" passive taint of rental real estate. To continue to apply this regulatory segregation under the new law defeats its purpose of providing passive loss relief to real estate professionals.

The typical real estate professional will segregate rental real estate activities from other real property activities, such as management, development and construction, to insulate those businesses against liability. For example, it is not uncommon for a real estate professional to own a limited partner interest in rental real estate and own 100% of a C corporation that is the general partner. It is not unusual for the real estate professional's hours devoted to a particular rental project to drop dramatically once the project is fully rented. The professional will move on and devote his time to new projects, leaving daily operations to employees.

The artificial segregation of rental activities that would be required by the proposed regulations for a real estate professional will perpetuate the passive taint on rental real estate that the new law was intended to relieve. Due to the nature of the business, the typical real estate professional often will not be able to meet the existing material participation requirements.

What should tax advisers do?

The proposed activity regulations do not specifically prohibit aggregation of limited partner interests in rental real estate with other interests in rental real estate. Thus, even before the RRA, a taxpayer could have grouped limited and general partner interests (as well as other interests in rental real estate) under the appropriate economic unit test. A sound and conservative approach in this situation would be to test this activity under the rules for limited partners. This approach makes even more sense after the RRA, since the grouping is sanctioned by the new statutory election. Beyond this suggested approach, tax advisers must wait for further official guidance.