Under the passive activity loss (PAL) rules, rental activities are generally considered passive activities with few exceptions. Consequently, many taxpayers find that the PAL rules broadly restrict the deduction of tax losses generated from their rental real estate activities. One exception to the passive treatment of a rental real estate activity occurs when the activity is operated by a taxpayer who qualifies as a "Real Estate Professional."
In order for a taxpayer to qualify as a Real Estate Professional (REP) there are two basic requirements that must be met annually. First, more than half of the personal services performed by the taxpayer during the year must be performed in real property trades or businesses. Second, the taxpayer must perform more than 750 hours of personal services during the year in real property trades or businesses. Whether an activity is considered a real property trade or business is based on all of the relevant facts and circumstances. For purposes of the aforementioned tests, personal services generally include any work performed in connection with a trade or business such as developing, managing, leasing, and selling real estate. However, any work performed as an investor would not qualify. In addition, personal services do not include services performed as an employee unless the taxpayer is at least a 5% owner of the employer.
In addition to the two requirements mentioned above, a taxpayer must also "materially participate" in an activity. Material participation must occur in order for the related personal services to be counted toward the two tests mentioned above and also to apply the REP exception to that activity. There are a number of ways a taxpayer can demonstrate material participation with respect to an activity, but some of these methods may not be available depending on the specific situation of the taxpayer. Nevertheless, effective tax planning may permit taxpayers to satisfy the material participation rules.
The material participation rules and their interaction with the generally favorable REP treatment are ambiguous enough to provide plenty of planning opportunities. Don't let your current real estate losses pile up on the shelf when there may be an opportunity for you to utilize those losses now. You should discuss your specific tax situation with your professional advisor to determine whether you might qualify as a Real Estate Professional and what the potential tax benefits of doing so might be.