Section 469 Passive Activities (2024)

An investment in a business or in real estate isoften made via a pass-through entity. A businessinterest is often held through an S corporation,and real estate is often held in a limited liabilitycompany taxed as a partnership, or in a partnership.Loss allocations to an owner/investor can be limitedas follows:

• The owner/investor must have basis in his ownershipinterest in the entity in order to be able to claim ashare of any loss.
• The owner/investor must have sufficient at-risk basis(capital invested and/or debt deemed to be held withrecourse to the owner) in order to be able to claimany loss.
• The loss must be classified as non-passive, or theowner/investor must have passive income, to offseta passive loss for any year except for the year ofdisposition of the entity that produces the loss.

The third hurdle, i.e. the passive loss test, can be thebiggest hurdle for the owner/investor. With few exceptions,an activity involving conduct of a trade or business isdeemed to be a passive activity if the investor/owner doesnot materially participate.

MATERIAL PARTICIPATION

A taxpayer can avoid having his interest in a trade or businessdeemed passive by materially participating in the trade orbusiness. Material participation is determined annually withseven separate tests. Satisfying any one of the seven willresult in non-passive status for the activity for the yearin question. A taxpayer is considered to materially participatein an activity if any one of the following tests is satisfied:

1. The participation is for more than 500 hours.
2. The participation constitutes substantially all of theparticipation in the activity by all individuals (includingnon-owners) for the tax year.
3. He or she participates in the activity for more than100 hours during the tax year, and such participationis not less than the participation of any other person.
4. The activity is a significant participation activityfor the tax year, and aggregate participation in allsignificant participation activities during the yearexceeds 500 hours. A significant participation activityis one in which the taxpayer has more than 100hours of participation during the tax year but fails tosatisfy any other test for material participation.
5. The taxpayer has materially participated in the activityfor any five of the 10 tax years immediately precedingthe tax year in question. The five tax years need notbe consecutive.
6. The taxpayer has materially participated in any threepreceding years if the activity is a defined personalservice activity. A personal service activity is one thatinvolves the performance of personal services inthe fields of health, law, engineering, architecture,accounting, actuarial science, performing arts,consulting or any other trade or business in whichcapital is not a material income-producing factor.
7. The taxpayer participates regularly, continuouslyand substantially, taking into account all facts andcirc*mstances.

There are someservices of an owner/investor that aredisregarded in applyingthese materialparticipation tests. For example, servicesperformed as an investor in studying and reviewing financialstatements of the activity or monitoring the finances oroperations of the activity in a non-managerial capacity isnot considered unless the owner/investor is also involvedin the daily management of the business.

Separate activities can be aggregated in order to satisfyone of the material participation tests. Therefore, it may beadvantageous to group several different entities into asingle activity. Although the investor/owner may use anyreasonable method for grouping, IRS regulations give thefollowing factors the greatest weight in determiningwhether activities can be combined: similarities anddifferences in types of businesses, the extent of commoncontrol, the extent of common ownership, geographicallocation and interdependencies between the activities.

RENTAL ACTIVITIES

Rental activities are generally subject to an automaticpassive classification under Internal Revenue Code Section469. However, there are exceptions for qualifying realestate professionals and certain active-participation realestate rental activities. Additionally, for an owner of rentalproperty who performs services such as securing tenantrentals and approving capital improvements, if adjustedgross income is less than $150,000, a limited amountof losses from the real estate rental activities will be treatedas non-passive each year. The losses of these “activelyparticipating” owners are limited to $25,000 each year.

Code Sec. 469 allows an owner/investor who has moresubstantial participation in real estate activities to beconsidered a real estate professional. If the owner/investorperforms more than one-half of his personal services inreal property trade or business activities and also performsmore than 750 hours of personal services in real propertytrade or business activities, then real estate rental activitiesare not subject to automatic passive classification. A realproperty trade or business is any real property development,redevelopment, construction, reconstruction, acquisition,conversion, rental, operation, management, leasing, orbrokerage trade or business. Services performed by anemployee are not treated as performed in real propertytrades or businesses, unless the employee is at least a5% owner.

Meeting the material participation tests under Section 469and the regulations requires significant planning andinvolvement on the part of the owner/investor. These rulesand regulations are complex. Anyone considering aninvestment that will require their active involvement shouldconsult their tax advisor and review these provisions carefully.