A Material Misunderstanding

Congress most likely believed it was doing real estate professionals and their advisors a favor when it enacted Section 469(c)(7). That section excepts real estate professionals from limits on losses (and tax credits) generated on real estate rental activity. Those limits generally apply to passive activities. Under passive activity rules, taxpayers can deduct net passive activity losses only in certain cases. One of those cases applies when a taxpayer materially participates in an activity. This material participation case generally does not apply to losses generated from rental activities, though. Rental activity is per se “passive” under passive activity rules of Section 469. In other words, generally, no matter how much time a taxpayer spends on a real estate rental activity, all losses from that activity will be passive losses.

Section 469(c)(7) tweaks this per se rule in cases where the taxpayer is a real estate professional and the losses are from real estate rental activity. The losses in that case are deductible if that professional materially participates in the activity. 

Congress may have thought it was doing us a favor, but they actually created a trap for all but the most careful taxpayers and advisors. This post surveys the rules that apply for the real estate professional exception of Section 469(c)(7). It does not go into detail. Detailing technical rules would risk overwhelming the points I am trying to make in this post:

  • The real estate professional exception is available in limited cases. Qualifying for the exception is not as easy as the title of the exception implies or as easy as many in the profession believe; and
  • The real estate professional exception can be a cruel tease even to those who qualify. Supporting a claim to the exception requires some good record keeping about how the taxpayer spends time. With deep respect and admiration for my colleagues in the real estate industry – especially real estate developers – many are not naturally inclined (and don’t have the patience) to keep contemporaneous records of time spent.

The Real Estate Professional

The exception under Code Section 469(c)(7) only applies to a person if that person passes two separate tests:

  • The Personal Services Test, and
  • The 750 Hour Test

The Personal Services Test

The Personal Services Test is satisfied if:

  • The taxpayer performs personal services in real property trades or businesses during a given year,
  • The taxpayer materially participates in one or more of those real property trades or businesses for that year (the “Material RP Businesses”), and
  • More than half of the personal services performed by the taxpayer during a given year are performed in the Material RP Businesses.

A “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

The key elements of this test are:

  • Materially participating in one or more real property trades or businesses, and
  • Performing more than half of personal services for the year in those businesses.

For example, if you spend all of your time in a real estate brokerage business in which you materially participate, then you pass the test.

If you spend half of your time performing personal services in a business management consultancy and half in managing your real estate rental properties, you do not qualify (must be MORE than half).

If you devote all of your personal services to a real property trade or business but do not materially participate in that business, you do not qualify.

The 750 Hour Test

The 750 Hour Test is satisfied only if you devote at least 750 hours in the Material RP Businesses. So, if you are a material participant in only one Material RP Business because you are the only one who participates in that business (See Treas. Reg. 1.469-7(a)(2)), but you participate less than 750 hours in that trade or business, you will not qualify for the real estate professional exception. Further, for this rule, you don’t count the participation of your spouse. So, if you and your spouse collectively participate more than 750 hours, but you participate less than 750 hours, you will not qualify.

As you can see, satisfying material participation tests matters a lot in determining whether one is a real estate professional. Satisfying the material participation test on audit requires record keeping to show your participation. Contemporaneous record keeping carries a lot of weight. Reconstructed record keeping in the heat of an audit does not. So, if you intend to rely on the real estate professional exception, it’s best to keep records of participation in your real property trades and businesses.

Material Participation in the Rental Activities

Even if you are a real estate professional, you will not get the benefit of Section 469(c)(7) unless you materially participate in the rental activity that generates the passive loss. Sometimes, the records that you keep for establishing that you are a real estate professional will suffice to establish that you materially participate in the rental activity, too. Managing rental properties is a real property trade or business.

You may, however, be required to supply evidence of material participation for your rental activity that is completely different from the evidence you use for the real estate professional tests. In those cases, you have an option that can be very useful. Under Treas. Reg. 1.469-9(g), a real estate professional can group real estate rental activities for the material participation test. If elected, grouping combines the rental activities as though they were one activity. If you materially participate in that one grouped activity, you are a material participant for all of the activities in that group. So, for example, let’s say you are invested in five real estate rental activities and you participate at least 500 hours a year in three of them. If you elect the grouping exception, you can treat all five of the activities as activities in which you are a material participant.

Use care in making this grouping election. Before making the election, you need to discuss its implications with your accountant.


Satisfying the Section 469(c)(7) exception does not simply apply to everyone who participates in real property trades or businesses. Further, and most importantly, it does not apply to everyone who qualifies as a “real estate professional”. The exception only applies to a real estate professional that is a material participant in the rental activity that generates the loss.

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