WHICH IS THE BETTER EXCEPTION FOR A HIGH-INCOME TAXPAYER TO AVOID THE SUSPENSION OF BUSINESS LOSSES?

The purpose of this article is to enhance the awareness of the high-income taxpayer as to how to avoid the suspension of rental real estate business losses under I.R.C. § 469—treated as passive activity losses—by... [ view full abstract ]

The purpose of this article is to enhance the awareness of the high-income taxpayer as to how to avoid the suspension of rental real estate business losses under I.R.C. § 469—treated as passive activity losses—by satisfying either (1) Treas. Reg. § 1.469-1T(e)(3)(ii)(C), i.e., the “extraordinary personal services” exception to the passive activity loss (PAL) rules under I.R.C. § 469, or (2) I.R.C. § 469(c)(7), i.e., the “real estate professional” exception to those PAL rules. Specifically, under either Treas. Reg. § 1.469-1T(e)(3)(ii)(C) or I.R.C. § 469(c)(7), if the particular requirements are met, the per se “passive activity” rule for rental real estate activities under I.R.C. § 469(c)(2) does not apply.

To qualify for the “extraordinary personal services” exception under Treas. Reg. § 1.469-1T(e)(3)(ii)(C), under a two-pronged test, the taxpayer must be able to offer competent evidence that the taxpayer provided personal services to renters of tangible property (e.g., real estate) “in connection with making such property available for use.” Also, from the perspective of the renter of real estate (a subjective determination), the taxpayer must be able to show that the use by the renter of the real estate was incidental to the renter’s receipt the personal services provided by the taxpayer. In other words, the taxpayer must show that the renter was motivated to rent the real estate to receive the personal services provided by the taxpayer, e.g., that the use of the real estate by the renter was just an “incidental” benefit to the receipt of the personal services provided to the renter by the taxpayer “in connection with making such property available for use” to the renter.

In contrast, under the “real estate professional” exception of I.R.C. § 469(c)(7), the per se “passive activity” rule for rental real estate activities under I.R.C. § 469(c)(2) does not apply to a rental real estate activity of a “real estate professional” for any tax year within which such person satisfies the real estate business participation requirements of I.R.C. § 469(c)(7)(A)(i)—an objective test. A person meets these requirements if such person performs:

(1) more than 750 hours of personal service during the tax year in designated real property trades or businesses in which the person materially participates (a “750-Hour Personal Service Test”), where

(2) more than one-half of the personal services performed in all trades or businesses during the tax year were performed in designated real property trades or businesses in which the person materially participates (a “50% Personal Service Test”) [I.R.C. § 469(c)(7)(B)].

Within this context, a person who participates in at least one rental real estate activity and who meets the above real estate business participation requirements is a qualifying “real estate professional” within the meaning of I.R.C. § 469(c)(7) [Treas. Reg § 1.469-9(b)(6)].

Under either of the above exceptions [Treas. Reg. § 1.469-1T(e)(3)(ii)(C) or I.R.C. § 469(c)(7)], I.R.C. § 469(c)(2) does not apply. Instead, I.R.C. § 469(c)(1) applies. If I.R.C. § 469(c)(1) applies to a taxpayer’s rental real estate business under Treas. Reg. § 1.469-1T(e)(3)(ii)(C) for a particular tax year, said business is a non-passive activity for such tax year (i.e., rental real estate business losses are fully deductible against non-passive income), but only if the taxpayer materially participates in the rental real estate business for that year. On the other hand, if I.R.C. § 469(c)(1) applies to a rental real estate activity of a qualifying “real estate professional” under I.R.C. § 469(c)(7), said activity of a qualifying “real estate professional” is a non-passive activity for such tax year (i.e., rental real estate losses are fully deductible against non-passive income), but only if said “real estate professional” materially participates in such real estate activity for that year (e.g., participation in the activity for more than 500 hours) [Treas. Reg. § 1.469-9(e)(1)].

In a case study approach, the three primary objectives of this article are:

(1) To establish the factual background surrounding the case study;

(2) To establish the law at issue; and

(3) To apply the law at issue to the factual background for the purpose of identifying implications for the high-income taxpayer in avoiding the suspension of rental real estate business losses – treated as passive activity losses—under the PAL rules of I.R.C. § 469.

This article argues that if these objectives are met, the high-income taxpayer will have a greater understanding of the intricacies of I.R.C. § 469 and be in a better position to choose the best exception alternative to avoid the suspension of rental real estate business losses under I.R.C. § 469—treated as passive activity losses—by satisfying either (1) Treas. Reg. § 1.469-1T(e)(3)(ii)(C), i.e., the “extraordinary personal services” exception to the PAL rules under I.R.C. § 469, or (2) I.R.C. § 469(c)(7), i.e., the “real estate professional” exception to the PAL rules.

In a case study approach, this article accomplishes its purpose and objectives in a stepwise fashion as follows.

• In Part I, the factual background surrounding the case study is established.

• In Part II, the federal tax law concerning the PAL rules under I.R.C. § 469 is identified.

• In Part III, the federal tax law concerning the “extraordinary personal services” exception to the PAL rules under I.R.C. § 469 is identified (Subpart A) and the federal tax law concerning the “real estate professional” exception to the PAL rules under I.R.C. § 469 is identified (Subpart B).

• In Part IV, the law at issue under I.R.C. § 469 is applied to the factual background for the purpose of establishing particular legal conclusions about the federal income tax consequences of the application of I.R.C. § 469.

• In Part V, implications of the findings in Part IV for the avoidance by the high-income taxpayer of the suspension of business losses—treated as passive activity losses—by satisfying either (1) Treas. Reg. § 1.469-1T(e)(3)(ii)(C), i.e., the “extraordinary personal services” exception to the PAL rules under I.R.C. § 469, or (2) I.R.C. § 469(c)(7), i.e., the “real estate professional” exception to the PAL loss rules under I.R.C. § 469, are presented.