Increased savings for R.E. professionals: Meeting the strict rules by making an aggregated election

Most individuals cannot offset their earned or investment income with net rental losses unless they are a real estate professional (REP). If you are an REP, then the tax laws allow you to deduct your annual rental real estate losses against your other income. Also, REP's are not subject to the new 3.8% Medicare tax if the real estate generates income. So REP's get the best of both worlds - deductible losses and 3.8% tax savings on their income! Qualifying as a Real Estate Professional: Unfortunately, qualifying as a REP may not be so easy. Recently, there have been several tax court cases explaining what it takes to become an REP. To qualify, you have to meet 2 tests. First, you must spend more than half of your personal service hours during the year in real property trades or businesses in which you materially participate and, secondly, you must spend more than 750 hours of service during the year in real property trades or businesses in which you materially participate. For a doctor that works over 40 hours per week for 50 weeks in medicine and owns rental real estate, to meet this test, that doctor will need to work at least 1 hour more in real estate than in medicine to meet this first test. The second test requires the person to spend at least 750 hours during the year in real property trades or businesses. A recent tax court case demonstrates how tough it is to meet these 2 tests. In this tax court case, a full time research consultant was expected to work 40 hours per week at his company. The consultant submitted time sheets during the year in which he reported over 1,900 hours worked. This consultant owned 28 apartment units and he performed various duties for the rental properties including repairs, research of landlord/tenant laws and other management activities. The consultant wasn't able to demonstrate, to the satisfaction of the tax court, that the consultant's hours in real estate activities were greater than the hours worked as a consultant. While the tax rules don't require REP's to maintain contemporaneous records or documenting hours worked, the court might have sided with the consultant had he maintained timesheets or documentation supporting his hours between his research employment and his real estate activities. Materially Participating in Real Estate: After satisfying the 2 tests, an REP must materially participate in the real estate rental activities. Material participation is met when the person participates in the activity for more than 500 hours during the year, the person participates in the activity and that time spent represents substantially all of the participation in that activity, the person participates in the activity for more than 100 hours during the year and his participation is not less than any other person, or the person participates in significant activities and the aggregate participation in all significant participation exceeds 500 hours. Under the tax regulations, each rental activity is treated as a separate activity for material participation. Therefore, if you own several rental properties, it is very difficult to materially participate in each property without considering an aggregation election. Aggregation Election: If an aggregation election is made, then all the rental properties are taken into account as one activity for the material participation requirements. Once you materially participate as an REP in your rental properties, then you are able to offset your rental losses against your other income. Avoiding the Medicare Tax: Until 2013, if your rental properties generated net income, there really wasn't any tax savings to be an REP. Effective 2013, investment income, including passive rental income, will be subject to an additional 3.8% Medicare income tax if your income exceeds $250,000. It should be noted that REP's are not subject to the Medicare tax on rental real estate income on properties that the REP materially participates in. Therefore, an REP may avoid the Medicare tax by materially participating in their real estate activity. Many real estate owners may have never made an aggregation election as their properties were income producing. So, there is time to avoid the Medicare tax by making the election. Conclusion: In light of recent tax court decisions and changes in tax laws, many REP's may want to substantiate their time spent on real estate and non-real estate activities to support their losses and, if income generating, avoid the Medicare tax. Many REP's with more than one property will find it simpler to meet the strict REP rules by making the aggregation election. Barry Sunshine, CPA, Alan Hoffman, CPA , and Eric Fried, CPA are tax partners at Janover LLC, Garden City and New York, N.Y.