An investment in a business or in real estate is often made via a pass-through entity. A business interest is often held through an S corporation, and real estate is often held in a limited liability company taxed as a partnership, or in a partnership. Loss allocations to an owner/investor can be limited as follows:
- The owner/investor must have basis in his ownership interest in the entity in order to be able to claim a share of any loss.
- The owner/investor must have sufficient at-risk basis (capital invested and/or debt deemed to be held with recourse to the owner) in order to be able to claim any loss.
- The loss must be classified as non-passive, or the owner/investor must have passive income, to offset a passive loss for any year except for the year of disposition of the entity that produces the loss.
The third hurdle, i.e. the passive loss test, can be the biggest hurdle for the owner/investor. With few exceptions, an activity involving conduct of a trade or business is deemed to be a passive activity if the investor/owner does not materially participate.
A taxpayer can avoid having his interest in a trade or business deemed passive by materially participating in the trade or business. Material participation is determined annually with seven separate tests. Satisfying any one of the seven will result in non-passive status for the activity for the year in question. A taxpayer is considered to materially participate in an activity if any one of the following tests is satisfied:
- The participation is for more than 500 hours.
- The participation constitutes substantially all of the participation in the activity by all individuals (including non-owners) for the tax year.
- He or she participates in the activity for more than 100 hours during the tax year, and such participation is not less than the participation of any other person.
- The activity is a significant participation activity for the tax year, and aggregate participation in all significant participation activities during the year exceeds 500 hours. A significant participation activity is one in which the taxpayer has more than 100 hours of participation during the tax year but fails to satisfy any other test for material participation.
- The taxpayer has materially participated in the activity for any five of the 10 tax years immediately preceding the tax year in question. The five tax years need not be consecutive.
- The taxpayer has materially participated in any three preceding years if the activity is a defined personal service activity. A personal service activity is one that involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting or any other trade or business in which capital is not a material income-producing factor.
- The taxpayer participates regularly, continuously and substantially, taking into account all facts and circumstances.
There are some services of an owner /investor that are disregarded in applying these material participation tests. For example, services performed as an investor in studying and reviewing financial statements of the activity or monitoring the finances or operations of the activity in a non-managerial capacity is not considered unless the owner/investor is also involved in the daily management of the business.
Separate activities can be aggregated in order to satisfy one of the material participation tests. Therefore, it may be advantageous to group several different entities into a single activity. Although the investor/owner may use any reasonable method for grouping, IRS regulations give the following factors the greatest weight in determining whether activities can be combined: similarities and differences in types of businesses, the extent of common control, the extent of common ownership, geographical location and interdependencies between the activities.
Rental activities are generally subject to an automatic passive classification under Internal Revenue Code Section 469. However, there are exceptions for qualifying real estate professionals and certain active-participation real estate rental activities. Additionally, for an owner of rental property who performs services such as securing tenant rentals and approving capital improvements, if adjusted gross income is less than $150,000, a limited amount of losses from the real estate rental activities will be treated as non-passive each year. The losses of these “actively participating” owners are limited to $25,000 each year.
Code Sec. 469 allows an owner/investor who has more substantial participation in real estate activities to be considered a real estate professional. If the owner/investor performs more than one-half of his personal services in real property trade or business activities and also performs more than 750 hours of personal services in real property trade or business activities, then real estate rental activities are not subject to automatic passive classification. A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services performed by an employee are not treated as performed in real property trades or businesses, unless the employee is at least a 5% owner.
Meeting the material participation tests under Section 469 and the regulations requires significant planning and involvement on the part of the owner/investor. These rules and regulations are complex. Anyone considering an investment that will require their active involvement should consult their tax advisor and review these provisions carefully.