Real Estate Income Strategy: Real Estate Professionals vs Material Participation Requirements

To convert rental real estate income from passive to nonpassive (active) for tax purposes, taxpayers must navigate two distinct sets of requirements: the “real estate professional” and the “material participation” standards. Understanding the differences between these requirements is crucial, as they determine whether rental losses and income can offset other nonpassive income and avoid certain tax limitations.

Section 469 of the Internal Revenue Code (“the Code”) generally treats all rental activities as passive, regardless of the taxpayer’s involvement. However, Section 469(c)(7) of the Code provides an exception for “real estate professionals.” To qualify, a taxpayer must satisfy both of the following tests during the tax year:

• More than half of the personal services performed in all trades or businesses by the taxpayer must be performed in real property trades or businesses in which the taxpayer materially participates.
• The taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

“Real property trades or businesses” include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage of real property. For joint filers, the requirements mentioned are satisfied if and only if either spouse separately satisfies them.

Qualifying as a real estate professional only removes the presumption that all rental activities are passive. To treat rental income or loss as nonpassive, the taxpayer must also “materially participate” in each rental activity. Taxpayers frequently overlook this second requirement, often believing that meeting the personal services requirements automatically satisfies the material participation requirement, which is not always the case. Material participation is defined in Section 469(h) of the Code and further detailed in Treasury Regulation 1.469-5T. The most common tests include:

• Participating in the activity for more than 500 hours during the year.
• Participation constitutes substantially all the participation in the activity.
• Participating for more than 100 hours and not less than any other individual.
• Based on all facts and circumstances, participation is regular, continuous, and substantial.

As explained, if both sets of requirements are met, any rental income received in the qualifying tax year shall be treated as active income. This is crucial because it allows taxpayers to take advantage of various tax opportunities. For example, eligible taxpayers can use losses from active rental activities to offset active income, such as wages or business income. By contrast, passive losses are generally limited to passive income or carried forward. Additionally, passive rental income is subject to the 3.8% net investment income tax. If the activity is nonpassive, the income may be excluded from this tax.

The test for being defined as a real estate professional should not be confused with the short-term rental strategy our team has discussed in previous articles. Under that strategy, if the average period of customer use of a rental property is less than seven days, the activity is not considered “rental activity,” as that term is defined, and is instead treated as a trade or business activity. 

To conclude, becoming a real estate professional under Section 469(c)(7) is only the first step; material participation is also required to treat rental income or loss as nonpassive. These distinctions are critical for maximizing deductions, minimizing tax on rental income, and ensuring compliance with the passive activity loss rules. For those considering leveraging this strategy, consulting a tax professional is advisable to ensure compliance and maximize the available tax advantages. Contact our team at (202) 455-6010 or schedule a confidential consultation