As the popularity of short-term rentals through services such as Airbnb and Vrbo continues, CPAs are facing more questions from their clients about how such rental income and expenses are treated for tax purposes. Those with losses from the activity may expect it will offset other taxable income. Thus, it is critical for tax practitioners to educate these clients regarding the Sec. 469 passive activity loss limitation rules and their exceptions. CPAs can then proactively advise them how to maximize tax benefits where opportunities exist and to minimize surprises come tax time.

Sec. 469 and Rental Real Estate
Sec. 469 defines a passive activity as any activity that involves a trade or business in which an individual taxpayer does not materially participate. For this purpose, a trade or business includes an activity to produce income for which expenses are deductible under Sec. 212 [Sec. 469(c)(6)]. Whether an individual materially participates in an activity is generally determined under the seven tests for material participation set out in Temp. Regs. Sec. 1.469-5T(a), discussed later.

Losses generated by passive activities (passive activity losses, or PALs) are only allowed to the extent of income generated by passive activities (passive income). PALs that cannot be used due to this limitation (suspended passive losses) are carried forward to subsequent years as PALs until they can be deducted against passive income [Sec. 469(b)]. In the year an entire activity is disposed of in a “fully taxable” transaction, any remaining suspended passive losses are no longer treated as PALs and are deductible [Sec. 469(g)].

Rental Real Estate Activities
Per Se Passive
In an exception to the material-participation standard, Sec. 469(c)(2) states that the term “passive activity” includes any rental activity, regardless of whether the taxpayer materially participates. Thus, rental real estate activities are commonly referred to as per se passive activities. What does Sec. 469 and its application to rental real estate activities mean for the average landlord? Let’s look at a simple example, assuming this individual’s only other taxable income is wages of $200,000 and she has the income and expenses from a single real estate rental property in 2023 as shown in the following:

Income and Expenses from Rental Activity

Rental income | $36,000

Rental expenses:
Mortgage interest | $20,000
Property taxes | $5,000
Utilities | $ 2,500
Repairs | $5,000
Depreciation | $14,000
_____________________________________           

Rental expenses total | $46,500
Net rental income/(loss) | $(10,500)

 
For tax purposes, the net rental loss for the year will be limited to $0, with $10,500 of PALs carried over to 2024. The individual’s taxable income for the year is $200,000, with $10,500 of suspended passive activity losses.

If the individual had $5,000 of net passive income from another source, the loss from the rental property would be available to offset that income, such that net passive income would be $0, with $5,500 of suspended passive losses carried over to 2024.

Active Participation
A limited exception from the PAL rules exists for individuals with rental real estate activities who participate in the activities, but their participation does not rise to the level of material participation. For individuals who “actively participate” in the rental activity and whose adjusted gross income (AGI) is less than $150,000 ($75,000 for married taxpayers filing separately), up to $25,000 of net passive losses from rental real estate are allowed to offset other taxable income each year [Sec. 469(i)]. AGI for this purpose does not include any allowable passive activity or real property business losses.

Active participation does not require as much involvement in the activity as material participation. Active participation can consist of making management decisions, but it excludes any activities in which the taxpayer owns less than 10 percent (by value) of all interests in the activity or an interest as a limited partner in a limited partnership (Sec. 469(i)(6)). If the taxpayer is married, however, the spouse’s participation also counts.

The $25,000 starts to phase out at an AGI of $100,000 ($50,000 for married filing separately) and is reduced by 50 percent of the amount by which the AGI exceeds this threshold. In the example above, if the individual’s AGI were $130,000, the maximum $25,000 allowance would be reduced by: ($130,000 – $100,000) × 50 percent = $15,000, allowing her to deduct up to $10,000 ($25,000 – $15,000) of total net rental losses. The remaining $500 of passive activity loss would be carried over.

Short-term rentals
Under Temp. Regs. Sec. 1.469-1T(e)(3)(ii), short-term rentals (in which the average rental period is either (1) seven days or less or (2) 30 days or less (with significant personal services provided by or on behalf of the taxpayer) are not classified as rental activities. Thus, short-term rentals (as Airbnb rentals often are) are not considered per se passive, the $25,000 rental real estate allowance for active participation does not apply, and hours spent in short-term rentals do not count toward meeting the real estate professional tests discussed below.

The determination of whether a short-term rental activity is passive or nonpassive depends on whether the individual materially participated in the activity, as discussed below.

Self-Rental Rule
Under the self-rental rules, if an individual rents property to an activity in which he or she materially participates [which is not property rented incidental to a development activity under Temp. Regs. Sec. 1.469-2T(f)(5)] and generates net rental income for the year, such net income (including any gains from the sale or disposition of the property) is recharacterized as nonpassive income for that year. This is to prevent taxpayers from inflating rent to free passive losses from other activities. If the property generates a net loss for the year, the losses continue to be passive.

Real Estate Professional
As noted, rental activities are generally per se passive activities, regardless of an individual’s level of participation in the activities. However, if an individual qualifies as a real estate professional, his or her rental real estate activities are not per se passive and will not be passive activities if the individual materially participate in the activities. To qualify as a real estate professional, an individual must satisfy two time-related requirements during the applicable tax year:

1. More than 50 percent of all personal services performed in trades or businesses by the individual during the year were performed in real property trades or businesses in which he or she materially participated; and

2. The individual must have worked more than 750 hours in real property trades or businesses in which he or she materially participated [Sec. 469(c)(7)(B)].

Real property trades or businesses are defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business” [Sec. 469(c)(7)(C)].

If an individual has a full-time job outside the real property business, it will be very difficult (if not impossible) to meet these tests. Also, services performed as an employee do not count unless the employee is at least a 5 percent owner. In addition, unlike with the $25,000 rental real estate allowance for active participation discussed above, a spouse’s personal services are not attributed to a taxpayer for purposes of meeting these time requirements. 

The determination of whether an individual qualifies as a real estate professional is made annually, meaning an individual could qualify one year but not the next. If an individual qualifies, contemporaneous documentation to support how one spent one’s time in a manner that meets these requirements is critical in the event of an IRS audit.

CPAs should impress upon clients that the IRS and courts will scrutinize their time records for completeness, accuracy and plausibility; a “ballpark guestimate” will not suffice (see Bailey, T.C. Memo. 2001-296). Time logs must reflect hours in which the taxpayer performed services in their real property trades or businesses. Time spent “on call” for work at rental properties in a rental real estate activity, for example, does not count [see Moss, 135 T.C. 365 (2010)].

As noted above, an individual who qualifies as a real estate professional does not automatically get to treat all rental real estate activities for the year as nonpassive. The individual must still materially participate in each rental real estate activity for it to be nonpassive. Under Sec. 469(c)(7), however, an individual can elect to aggregate all of his or her rental real estate activities and consider all such activities as one activity for purposes of determining material participation.

The election is advantageous when an individual is involved in multiple rental activities and the taxpayer would have difficulty meeting any of the material-participation tests (discussed below) for each activity separately. Taxpayers should give careful consideration before making the election, however, as it is irrevocable.

Also note that not all states conform to the real estate professional exception. For example, California does not conform, meaning rental real estate activities of a real estate professional are still treated as per se passive for California personal income or franchise tax purposes.

Material Participation
Temp. Regs. Sec. 1.469-5T(a) provides seven tests which an individual can satisfy to prove material participation in a trade or business. If any one of these tests is met (and assuming the per se passive designation for rental activities is overcome by meeting the real estate professional exception), an individual is considered to have materially participated in a rental real estate activity and that activity is treated as nonpassive for that tax year (and not subject to the passive loss limitations):

1. The individual participates in the activity for more than 500 hours during the tax year. The Sec. 469(c)(7) election to treat          all rental real estate activities as a single activity is particularly helpful in meeting this test. For example, say a real estate professional has five separate rental activities and spent 110 hours in each. Looking at each activity separately, he fails this test. However, by making the election to aggregate, he has spent 550 hours in his combined rental real estate activity and thus meets this test.

2. The individual’s participation in the activity for the tax year constitutes substantially all the participation of such activity of all individuals (including those who are not owners) for that year. An individual who does all or almost all the work in a rental activity would meet this test, but if an outside management company is hired, the 500-hour test is likely the only test available. Even if occasional third-party help (such as cleaners, landscapers or plumbers) is used, it may be difficult to meet this test.

3. The individual participates in the activity for more than 100 hours during the tax year, and his or her participation in the activity for the year is not less than the participation in the activity of any other individual (including those who are not owners) for that year. This is a slight variation of test No. 2, allowing for more outside help but first requiring at least 100 hours of the individual’s own involvement. For example, if an individual spent 120 hours on the activity during the year, he could hire a maintenance worker and a cleaner to work up to 119 hours each and still meet this test.

4. The activity is a significant-participation activity for the tax year, and the individual’s aggregate participation in all significant-participation activities during the year exceeds 500 hours. A significant-participation activity is a trade or business activity in which the individual spent more than 100 hours, but fewer than 500 hours, during the year. Note that for this test, a trade or business does not include rentals. This test is thus not available to a real estate professional.

5. The individual materially participated in the activity (by meeting any of the other six tests) for any five tax years (whether or not consecutive) out of the 10 tax years immediately preceding the tax year.

6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year. This is a variation of test No. 5, with a slightly less stringent criterion for personal service activities. A personal service activity involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting or any other trade or business in which capital isn’t a material income-producing factor. Rental real estate is not a personal service activity, so this test is also not available to a real estate professional.

7. Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year. This test does not apply unless the individual participated in the activity for more than 100 hours during the year. Time managing the activity does not count in determining whether the individual materially participated under this test if any person received compensation to manage the activity or if any person spent more hours than the taxpayer managing the activity.

What Counts as Participation in the Activity?
In general, any work done by an individual in connection with a rental real estate activity in which he or she owns an interest is treated as participation in the activity for purposes of the material participation tests. Under Sec. 469(H)(5), an individual’s participation includes his or her spouse’s participation in an activity. Some exceptions apply to the general rule, including:

• Work not usually performed by owners: Work is not treated as participation in the activity if it is both not the type of work customarily done by an owner of a rental real estate activity and one of the principal purposes the individual is doing the work is to avoid the disallowance of losses or credits due to the passive activity rules.

• Investor work: Unless an individual is involved in day-to-day management or operations of the activity, work in the capacity as an investor in the activity is not participation in the activity. According to Temp. Regs. Sec. 1.469-2T(f)(2)(ii)(B), work as an investor includes studying and reviewing financial statements or reports on operations of the activity, preparing or compiling summaries or analyses of the finances or operations of the activity for one’s own use, and monitoring the finances or operations of the activity in a nonmanagerial capacity.

Fully Taxable Dispositions
If a taxpayer does not have passive income from rental real estate or other sources to allow the use of passive losses generated by rental real estate activity, losses from that activity will continue to be carried over each year until the entire activity is sold in a fully taxable disposition.

The requirement that a disposition be “fully taxable” means that certain tax-free or tax-deferred transactions will not result in the release of passive loss carryovers upon a transfer of such property. This includes, but is not limited to, gifts, contributions to or distributions from a partnership, transfers due to death, and Sec. 1031 like-kind exchanges.

Tax practitioners should keep this in mind so passive losses are not erroneously accelerated when such a transaction occurs. This can happen when relying on tax preparation software, which often provides a box to indicate 100 percent disposition and will release any passive activity losses attributed to the activity. 

Because the entire activity must be disposed of for the suspended losses from the transaction to be deductible, if a real estate professional has made the irrevocable election to group multiple rental real estate activities together as a single activity, generally any suspended passive losses from such activities will not be freed up until all such activities have been disposed of in a fully taxable transaction. Since the election is to treat all the activities as a single activity, the disposition of one of the grouped activities is considered a partial disposition of the grouped activity, not a disposition of the entire activity.

However, if substantially all the activities that are grouped as a single activity are disposed of in a partial disposition and certain requirements are met, the suspended passive losses associated with the disposed of activities will be allowed.

Equipped to Advise Clients
This article is intended to be an overview of the more common tax issues as they relate to rental real estate activities. The passive activity loss rules under Sec. 469 are complex, and the per se passive rule adds another layer of complexity.

It’s critical for tax advisers to know to consider the aggregation election, advise clients of the importance of concurrent documentation and understand the material-participation rules. Also, when dealing with clients who rent out their properties on a short-term basis, it is helpful to keep in mind that short-term rentals are not considered rental activities that are per se passive under the passive activity loss rules.

This article is reprinted with the permission from the Journal of Accountancy.