Case — Rental Real Estate Losses

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TL Case Summ

THE QUESTION

Do activities related to short-term rentals count toward the 750-hour material participation test and allow a current deduction for losses?

THE DISPUTE

Taxpayer Says: Time spent on all real estate activities exceeded the 750-hour requirement for the “real estate professional” exception to passive loss limitations. Losses from the activities are currently deductible.

Internal Revenue Service Says: One of the rental activities involved short-term rentals of seven days or less, and time spent managing that activity is not counted toward the 750-hour requirement. The rental activity losses are passive and cannot be deducted in full in the current year.

THE LAW

From Internal Revenue Code Section 469(c)(7): One of two main exceptions to the general rule that rental activities are passive activities. This exception is available to “taxpayers in real property business” (real estate professionals).

From Internal Revenue Code Section 469(c)(7)(B): To qualify as a real estate professional, a taxpayer must satisfy both of the following requirements: (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

From Internal Revenue Code Section 469(c)(7)(A): To compute the 750 hours, the code treats each real estate activity as a separate activity unless the taxpayer makes an election to combine some or all of the activities.

From Federal Tax Regulation 1.469-1T(e)(3)(ii)(A): “An activity involving the use of tangible property is not a rental activity” for a year if, among other reasons, “the average period of customer use for such property is seven days or less” during the year.

THE CAUSE OF THE DISPUTE

In general, losses from rental real estate activities are considered “passive.” You can currently deduct losses from passive activities only in certain situations. These exceptions include: you have passive income; you actively participated in an activity and qualify for a $25,000 special allowance; you sell the property; or you are a real estate professional.

To be considered a real estate professional, you must meet “material participation” rules. For your losses to be deductible, those requirements state you have to spend at least 50% of your time and more than 750 hours in real estate activities and you must materially participate in each rental activity (unless you choose to combine your activities).

The dispute in this case arose around the definition of real estate activities, which affects what time counts toward the 750-hour rule. The code describes a “real property trade or business” as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” However, six types of activities are normally defined as rentals, yet can be treated as non-rental activities. See Federal Tax Regulation 1.469-1T(e)(3)(ii)(A) above for one example.

In this case, the taxpayer owned four rental properties, and spent a total of 1,003 hours managing and otherwise working on them. Three of the properties were long-term rentals (generally a year or more), and were reported on Schedule E (Supplemental Income and Loss). One property was rented for an average of three days at a time, and was reported on Schedule C (Profit or Loss from Business). The taxpayer made an election to combine the activities. Based on the code’s definition of a real property trade or business, she included time spent on all the properties for purposes of computing the 750- hour requirement for a real estate professional, and she deducted current year losses in full.

The IRS says the short-term rental property is not considered a rental activity, meaning those hours had to be separated from time spent on the other properties. Because the taxpayer only spent 679 hours on the other three properties, the real estate professional exception was not met and losses from those activities were not fully deductible in the current year.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 43KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. A rental property with average use of less than seven days is not an activity a taxpayer can include in computing the more-than-750-hours of services needed to qualify as a real estate professional. The 679 hours the taxpayer spent on all her rental real estate activities excluding the short-term rental are less than the 750 hours required to qualify as a real estate professional. Consequently, the other activities are passive, and the loss is not allowed for the year in question.
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