8022 / What is material participation in rental real estate?

A rental real estate activity of a taxpayer is not automatically considered a rental activity (see Q 8011) subject to the passive loss rules for a year, but only if during the year (1) more than one-half of the personal services performed by the taxpayer in trades or businesses during the year is in real property trades or businesses (see below) in which the taxpayer materially participates (see Q 8011), and (2) the taxpayer performs more than 750 hours of service during the year in such real property trades or businesses (making the taxpayer a qualifying taxpayer). For purposes of (2), personal services performed as an employee are not treated as performed in a real property trade or business unless the employee is a 5 percent owner. In the case of a closely held C corporation, the requirements are considered met if more than 50 percent of the gross receipts of the corporation are derived from real property trades or businesses in which the corporation materially participates. With respect to a joint return, these requirements are met only if either spouse separately satisfies the requirements.¹ Work performed by the taxpayer’s spouse in a trade or business is treated as work performed by the taxpayer regardless of whether the spouses file a joint return.² Personal services do not include work performed in the individual’s capacity as an investor.³

Any interest in rental real estate, including real property held for the production of income under IRC Section 212, is considered a trade or business for purposes of the rental real estate with material participation exception.⁴ However, any rental real estate that the taxpayer grouped with a trade or business activity because the rental real estate was insubstantial in relation to the trade or business activity, or because the ownership interests in each activity were held in the same proportion (see Q 8016), is not an interest in rental real estate for purposes of the rental real estate with material participation exception.⁵ A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.⁶ A facts and circumstances approach is used in determining the taxpayer’s real property trade or business and, once determined, may not be changed unless the original determination was clearly inappropriate or a material change in circumstances has occurred that makes the earlier determination clearly inappropriate.⁷ Each interest of a qualifying taxpayer in rental real estate will be treated as a separate rental real estate activity, unless an election is made to treat all rental real estate as a single activity (see below). A qualifying taxpayer may not group a rental real estate activity with any other activity.⁸

A qualifying taxpayer may elect to treat all interests in rental real estate as a single rental real estate activity and that election is binding for the taxable year in which it is made and for all future years in which the taxpayer is a qualifying taxpayer unless the taxpayer revokes the election because of a material change in circumstances. If a taxpayer makes this election and at least one rental real estate interest is held by the taxpayer as a limited partnership interest, the combined rental real estate activity will be treated as a limited partnership interest for the purpose of determining material participation (see Q 8011) unless the taxpayer’s share of gross rental income from all limited partnership interests in rental real estate is less than 10 percent of his or her share of gross rental income from all interests in rental real estate for the year.⁹

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Planning Point: The election may be made in any year in which the taxpayer is a qualifying taxpayer, and the failure to make the election in one year does not preclude the taxpayer from making the election in a subsequent year. ¹⁰

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The fact that an election is less advantageous to the taxpayer in a particular taxable year is not, of itself, a material change in the taxpayer’s facts and circumstances. Similarly, a break in the taxpayer’s status as a qualifying taxpayer is not, of itself, a material change in the taxpayer’s facts and circumstances.¹¹

In the absence of an election by a qualifying taxpayer, interests in rental real estate held by a partnership or S corporation pass-through entity are treated as one or more activities as grouped by the pass-through entity. See Q 8016.However, if the election is not made and the qualifying taxpayer holds at least a 50 percent interest in the capital, profits, or losses, of a pass-through entity, each interest in rental real estate held by the pass-through entity is treated as a separate activity of the qualifying taxpayer, regardless of the way the pass-through entity groups activities. If one pass-through entity owns at least a 50 percent interest in the capital, profits, or losses of another pass-through entity, each interest in rental real estate held by the lower-tier entity will be a separate interest in rental real estate of the upper-tier entity regardless of the way the lower-tier entity groups activities.¹²

The $25,000 rental real estate exemption of IRC Section 469(i) (discussed above) also applies to the passive losses and credits from rental real estate activities (including prior-year disallowed passive activity losses and credits from rental real estate activities in which the taxpayer materially participates) of a qualifying taxpayer. The $25,000 rental real estate exemption is determined after application of the rental real estate with material participation rules. However, losses allowable under the rental real estate with material participation rules are not considered in determining adjusted gross income for purposes of phase-out of the $25,000 rental real estate exemption.¹³

Example: Al owns building X and building Y, both interests in rental real estate. In 2024, Al is a qualifying taxpayer under the rental real estate with material participation rules. Al does not elect to treat X and Y as one activity under the rental real estate with material participation rules. As a result, X and Y are treated as separate activities. Al materially participates in X, which has $100,000 of passive losses disallowed from prior years and produces $20,000 of losses in 2024. Al does not materially participate in Y, which produces $40,000 of income in 2024. Al also has $50,000 of income from other non-passive sources in 2024. Al otherwise meets the requirements of the $25,000 rental real estate exemption.

Because X is not a passive activity in 2024, the $20,000 of losses produced by X in 2024 are non-passive losses that may be used by Al to offset part of the $50,000 of non-passive income. Accordingly, Al is left with $30,000 ($50,000 – $20,000) of non-passive income. In addition, Al may use the prior year disallowed passive losses of X to offset any income from X and passive income from other sources. Therefore, Al may offset the $40,000 of passive income from Y with $40,000 of passive losses from X.

Because Al has $60,000 ($100,000 – $40,000) of passive losses remaining from X and meets all of the requirements of the $25,000 rental real estate exemption, Al may offset up to $25,000 of non-passive income with passive losses from X under the exemption. As a result, Al has $5,000 ($30,000 – $25,000) of non-passive income remaining and disallowed passive losses from X of $35,000 ($60,000 – $25,000) in 2024.¹⁴

A taxpayer may have regrouped his activities without regard to the manner in which they were grouped in the preceding taxable years for the first taxable year beginning after December 31, 1993, to the extent necessary or appropriate to take advantage of the rental real estate with material participation exception.¹⁵ See also Q 8016.