TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

Questions relating to the Internal Revenue Code’s material participation rules for losses frequently arise in the context of real estate businesses, where losses are common as a result of depreciation deductions and deductions for other costs incurred by the owner. This series will provide the fundamentals of the material participation rules as they relate to the real estate industry and will highlight intricacies and exceptions in the rules that tax professionals and taxpayers in the real estate industry should be attuned to.

Overview of Section 469. Section 469 of the Internal Revenue Code generally disallows taxpayers from using a loss incurred in a taxable year from a “passive activity” to offset ordinary income on their income tax returns.[i]  These losses are suspended and will be treated as a loss from that activity incurred in the subsequent taxable year.[ii]  Passive losses will remain suspended until there is either (1) income from a passive activity in a subsequent year that can offset the loss,[iii] or (2) until the taxpayer disposes of his entire interest in the activity, at which time all suspended passive losses from that activity can be deducted.[iv]  The Code’s passive loss rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations.[v]

Definition of Passive Activity. A passive activity is defined generally as any activity which involves the conduct of any trade or business and in which the taxpayer does not “materially participate.”[vi]   However, notwithstanding this general definition, Section 469 specifies that any rental activity will be treated as a passive activity, regardless of whether the taxpayer materially participated in the rental activity.  This makes rental activities per se passive, requiring all losses from rental activities to be suspended.

Treatment of Rental Real Estate. The Code carves out one exception to the rule that “passive activity” by definition includes any rental activity for certain taxpayers in the real property business (generally referred to as a real estate professional).  If a taxpayer satisfies the requirements of Section 469(c)(7) to qualify as a real estate professional,[vii] the rule that all rental activities are passive does not apply.[viii]  However, even if a taxpayer qualifies as a real estate professional within the meaning of Section 469(c)(7), that doesn’t mean the taxpayer’s losses from real estate rental activities will automatically become deductible.  The taxpayer must still prove that the rental activity is not a passive activity under the general rule, with additional limitations that apply that make it more difficult to satisfy the material participation requirement.[ix]

Section 469 also allows a limited $25,000 offset for losses from rental real estate activities for certain taxpayers who are natural persons, actively participated in the rental activity, and who satisfy the income requirements.[x]

Treatment of Other Real Estate Businesses. These limitations to deducting losses from rental real estate activities do not apply to other trades and businesses in the real estate industry.  For example, taxpayers who have an interest in a construction business or a real estate development business are subject to the general definition of a passive activity, which treats the activity as non-passive (thereby making the losses deductible), if the taxpayer materially participated in the activity.[xi]

The passive loss rules do not apply to taxpayers who are simply holding real property for investment—gain or losses incurred by a taxpayer from the disposition of real property that had been held for investment are instead subject the Code’s capital gain/loss rules.[xii]  However, regardless of a taxpayer’s investment intent, an interest in a rental property is not treated as property held for investment for purposes of the passive loss limitation rules.[xiii]

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] IRC § 469(a)(1).

[ii] IRC § 469(b).

[iii] The term “passive activity loss” for purposes of the Section 469 loss disallowance rules is defined as the amount by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year.  IRC § 469(d)(1).

[iv] IRC § 469(g).

[v] IRC § 469(a)(2).

[vi] IRC § 469(c)(1).

[vii] IRC § 469(c)7)(B), (C).

[viii] IRC § 469(c)(7)(A).

[ix] See Treas. Reg. § 1.469-9(e).

[x] IRC § 469(i).

[xi] See Treas. Reg. § 1.469-5T for the material participation tests.

[xii] IRC § 469(e)(1)(A)(ii); § 1221.

[xiii] IRC § 469(e)(1) (the flush language under § 469(e)(1) states that “any interest in a passive activity shall not be treated as property held for investment”).