New Guidance for Passive Loss Relief

By Bruce Bulloch, CPA, Marian O`Conor, CPA, and Julie M. Hardnock, CPA

In the mid-1980s, Congress wanted to perform economic "surgery" to excise the tax-shelter industry from the otherwise healthy economy. For this delicate operation, it chose just the right tool-a chainsaw: Internal Revenue Code (IRC) Section 469.

These passive-activity loss (PAL) rules not only closed down the tax-shelter industry, they played a leading role in perhaps the largest real estate downturn in U.S. history. The PAL rules also adversely affected a large number of taxpayers who really were "active" in real estate businesses, rendering their real estate income "ordinary" and fully taxable and their losses "passive" and largely nondeductible.

Finally, in 1994, Congress introduced IRC §469(c)(7), which relaxes the PAL rules for taxpayers actively involved in real estate businesses. However, the 469(c)(7) relief was tough to qualify for and provided no guidance about how these rules were supposed to work. On December 21, 1995, the Treasury released final regulations that expand the relaxation of the PAL rules, clarify some exceptions, and include procedures for taxpayers to take advantage of these benefits. These regulations allow certain losses to be treated as active instead of passive, based on the loss recipient's degree of participation in real property businesses.

Who Qualifies for Relief?
A rental real estate activity usually is passive under the PAL rules regardless of the level of the taxpayer's participation in it. However, the general rule does not apply to qualified real estate professionals who meet the following criteria:

• personal services performed in real property trades or businesses in which they materially participate amount to more than 750 hours, and
• real estate personal services amount to more than 50 percent of the total personal services performed in all trades or businesses during the year.

A taxpayer who satisfies these two requirements may not automatically deduct losses and use credits from rental real estate activities. Section 469(c)(7) merely creates an exception from the general rule that treats rental activities as passive activities. To deduct losses or use credits from a rental real estate activity without limitation by §469, a taxpayer must materially participate in that activity. A qualifying real estate professional who materially participates in a rental real estate activity treats it as any other business that is not subject to the PAL rules.

Participation: What Counts?
Management Activities. Under Reg. 1.469-9(E)(3)(ii), managing a piece of real estate counts toward the material participation standard, even if the management activity is conducted through a separate entity. However, only management relating to the taxpayer's own rental real estate interests counts.

Employee Activities. For purposes of determining if a taxpayer qualifies as a real estate professional, participation of employees counts during the portion of the tax year that the employee is a 5 percent or more owner of his employer.

Aggregation Election: What's It All About?
A real estate professional who owns more than one piece of rental real estate can aggregate them into one activity for purposes of the PAL rules, instead of treating each separately. Indeed, combining separate rental real estate activities may be the only way for an otherwise qualified real estate professional to satisfy the material participation requirement.

Should the election be made? The results will vary according to the mix of real estate and non-real estate activities and whether they are producing income or losses. To complicate matters, once the election is made, it is revocable only if there is a material change in the taxpayer's facts and circumstances.

In addition, this election is a double-edged sword. The final regulations clarify that a qualifying taxpayer who elects to treat all rental real estate interests as a single activity will be treated as having a single activity for all purposes of §469, including the former passive activity rules under §469(f) and the disposition rules under §469(g).

Herein lies the taxpayer's dilemma: Real estate professionals are allowed to treat post-1993 material participation rental real estate activities as nonpassive activities. However, such activities are treated as former passive activities if they carry previously disallowed losses. This characterization is significant because under §469(f)(1), previously disallowed losses from a former passive activity (in other words, from years in which the activity was subject to the PAL rules) can only offset income from that activity but cannot offset income from other activities. The only way to fully realize such losses against other income is to sell the former passive activity.

When Aggregation Can Help. Aggregation can benefit a qualifying real estate professional who owns rental activities carrying suspended losses (prior years' disallowed losses) and other rental activities generating income. Under Reg. 1.469-9(e)(1), if a property aggregated into one activity carries previously disallowed losses, these losses can offset income from other rental properties aggregated into the activity.

When Aggregation Can Hurt. Aggregation can be a liability if a formerly passive rental property carries large previously disallowed losses that are not likely to be absorbed by income from other properties, or if the qualifying real estate professional wants to sell the loss property. The election applies for all PAL purposes, including the disposition rules. As a result, the previously disallowed losses will not be released when the taxpayer sells the property that produced them, unless the property represents substantially all of the aggregated activity.

An Example
Assume John Smith owns three buildings. For 1995, building A shows $30,000 of disallowed PALs, building B shows $10,000 of disallowed PALs, and building C breaks even. In 1996, building A has $5,000 in income, building B has $5,000 net losses, and building C throws off $10,000 net income. John is a qualifying real estate professional for 1996 and materially participates in his three properties.

With Aggregation. If John makes the aggregation election in 1996, he'll show zero income from the overall rental real estate activity for the year. He will wind up with $10,000 of nonpassive income from the activity ($5,000 minus $5,000 plus $10,000). However, as a result of the election, the overall activity will be treated as a former passive activity, so the $10,000 net income from the activity can be offset by buildings A and B's suspended losses from prior years. After 1996, John will have $30,000 of remaining disallowed PALs ($40,000 of suspended PALs minus $10,000 used up in 1996).

Without Aggregation. If John doesn't make the aggregation election in 1996, since each property is a separate activity, he can't use the suspended losses from buildings A and B to offset the nonpassive income from building C. Building A's $5,000 income would be offset with $5,000 of previously disallowed loss from the former passive activity, and building B's net loss of $5,000 would offset $5,000 of building C's income, leaving $5,000 of fully taxable nonpassive income. John would have $35,000 of remaining suspended losses after 1996.

For 1996, John would clearly want to make the aggregation election. However, it can backfire if he wants to sell the property that produced the losses. In this example, the previously disallowed losses, treated as arising from a passive activity, would become fully available only if the properties that generated the losses represented substantially all of the aggregated activity and were sold, or if the entire activity were sold. Thus, taking advantage of this passive loss relief entails planning as well as crystal-ball gazing to predict uncertain future events.

Bruce Bulloch, CPA, a tax partner with Ernst & Young/Kenneth Leventhal Real Estate Group, serves many of the firm's real estate development, home-building, and REIT clients in the Baltimore and Washington, D.C., area.

Marian O'Conor, CPA, is a tax manager with Ernst & Young/Kenneth Leventhal Real Estate Group based in Baltimore.

Julie M. Hardnock, CPA, is a tax senior with Ernst & Young/Kenneth Leventhal Real Estate Group based in Baltimore.