Tax Tangles: Real Estate Agents (But Not Mortgage Brokers) May Qualify As Real Estate Professionals
This installment of Tax Tangles highlights a legal memorandum in which the IRS recently concluded that a real estate agent may qualify as a “Real Estate Professional” enabling income and losses from rental real estate to escape being “passive” for federal income tax purposes.
Readers interested in learning more about this subject or other tax issues affecting the real estate industry may contact Michael Grace, Counsel in our Washington, DC office, at 202-659-6776 or firstname.lastname@example.org.
To qualify as a real estate professional, an individual must work substantial hours in one or more “real property trades or businesses“ including, for example, development, construction, and management. Code Section 469(c)(7) details the rules and requirements; the Example below illustrates them.
For particular federal income tax purposes, qualifying real estate professionals may have non-passive income and losses from rental real estate activities in which they materially participate. Unlike rental income and losses generally, the items are not automatically passive. If a qualifying taxpayer materially participates, then rental real estate losses are not subject to the passive activity limitations (Internal Revenue Code Section 469), and rental real estate income is not subject to the 3.8% surtax on net investment income (Code Section 1411).
Agreeing with at least one court, the IRS, in a recently released legal memorandum, concluded that a real estate agent who brings together buyers and sellers may be engaged in a real property trade or business and thus may qualify as a real estate professional. The IRS also concluded that a mortgage broker cannot be a real estate professional. See ILM 201504010 (dated December 17, 2014 but only recently released).
Husband and Wife file joint federal income tax returns. They report income and losses from real estate rental properties.
Husband works in a business having nothing to do with real estate. He also spends more than 500 hours during the year managing the rental properties.
Wife spends no time on the rental properties. She works full time as a real estate agent representing individuals selling and purchasing real estate.
Assuming that Wife works as a real estate agent during the year more than 750 hours and more than 50% of her working time, she qualifies as a real estate professional. Because Husband and Wife file joint tax returns, Wife being a real estate professional qualifies both spouses as such. As a result, the couples income and losses from their rental real estate activities are not passive if either spouse materially participates in them.
By devoting more than 500 hours to the rental activities, Husband materially participates in them. Consequently, the income and losses the couple report on their joint returns are not passive.
Assume, for example, that in 2015 the rental properties generate net losses. They are not passive losses. Not limited to passive income, the losses can offset any income on the joint returns including husband’s salary and wife’s real estate commissions.
Assume that in 2016 the rental properties generate net income. It is not passive income. The rental income cannot be sheltered by any passive losses. Unlike rents generally, however, the income is not subject to the 3.8% surtax on net investment income.
In a court case preceding ILM 201504010, the United States Tax Court acknowledged the issue of whether a real estate agent may qualify as a real estate professional but saw no need to decide the issue under the particular facts before it. Hoskins v. Commissioner, TC Memo 2013-36. However, a federal district court in California has concluded that a real estate agent may qualify as a real estate professional. Gragg v. United States, 2014 TNT 63-15 (N.D. Calif. 2014).
Cautions and Trend
The IRS legal memorandum (ILM 201504010) was written to address issues raised in the IRS’ examining a particular taxpayer’s return. Technically, the memorandum does not represent legal precedent on which any other taxpayers may rely. Other courts may not necessarily agree with the memorandum or the court’s holding in Gragg. Nevertheless, the memorandum and relevant court cases signal a trend toward allowing real estate agents to qualify as real estate professionals with the favorable results previously described.