Tax planning opportunities for real estate professionals.

Sec. 469 suspends the deduction of passive activity losses. Before 1994, rental activities were automatically passive. The Revenue Reconciliation Act of 1993 provided some relief by exempting "qualified real estate professionals" from this rule. (See Tax Clinic, "Passive Loss Relief for Real Estate Professionals: Fact or Fiction?," TTA, May 1994, p. 278.)

To qualify for this exemption, Sec. 469(c)(7)(B) requires that, for a tax year, more than half of the 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 service hours must exceed 750 hours. Only real property trades or businesses in which the taxpayer materially participates are considered for these tests.

Therefore, for a number of qualifying taxpayers, certain activities changed (or will change) from passive to active. The rules relating to suspended losses from those former passive activities continue to provide opportunities for tax planning.

Sec. 469(f) allows the deduction of suspended losses generated by a former passive activity against the income generated by the same activity in a subsequent tax year when that activity is not passive. However, suspended losses from one former passive activity cannot offset income from another former passive activity. Qualified real estate professionals can apparently mitigate this problem through Sec. 469(c)(7)(A), which provides that "a taxpayer may elect to treat all interests in rental real estate as one activity."

Example 1: In 1992, T owned rental building A, which generated $50 in losses. In 1992, all rental activities were treated as passive; this loss was suspended and carried to 1993. In 1993, T purchased another rental building (B). In 1993, both buildings broke even; consequently, A's loss from 1992 remained suspended and was carried to 1994. In 1994, T became a qualified real estate professional. A broke even and B generated $50 of net income.

If, in 1994, T did not make an election to combine the activities, he cannot offset B's $50 of income with A's suspended losses. His combined taxable income from both activities is $50. On the other hand, if T made a Sec. 469 (c) (7) (A) election, he could have offset B's income with A's loss, eliminating the suspended loss and reducing his combined taxable income from both activities to zero.

According to Regs. Sec. 1.469-9(g)(1), the election to combine activities can be made in any year in which the taxpayer is a qualified real estate professional. The election is binding for the tax year for which it is made and for all future years in which the taxpayer is a qualified real estate professional, even if there are intervening years in which the taxpayer does not qualify. The election must be made by attaching a statement to the taxpayer's original income tax return for the tax year.

This election may be revoked only in the tax year in which there is a material change in the taxpayer's facts and circumstances 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 (Regs. Sec. 1.469-9(g)(3)). Regs. Sec. 1.469-9(g)(2) states that: "The fact that an election is less advantageous to the taxpayer in a particular taxable year is not, of itself, a material change in the taxpayer's facts and circumstances. Similarly, a break in the taxpayer's status as a qualifying taxpayer is not, of itself, a material change in the taxpayer's facts and circumstances."

Failure to make this election in one year does not preclude the taxpayer from making the election in a subsequent year. If, in any particular year, the taxpayer is not a qualified real estate professional, the election will not have effect for that year.

Example 2: T previously worked in an accounting firm and did not qualify as a real estate professional. He retired from accounting in 1998 and became a qualified real estate professional. T can make the election in 1998, the first tax year in which he is a qualified real estate professional. If T does not make this election for 1998, he can make it for 1999 if he is a qualified real estate professional for that year.