How to Make the Section 469(c) Election for Real Estate

The Internal Revenue Code’s Passive Activity Loss (PAL) rules, found in Section 469, prevent taxpayers from deducting losses from passive activities against non-passive income like wages or investment earnings. Rental real estate is automatically defined as a passive activity, meaning any losses generated are suspended and can only be used to offset passive income.

A provision in Section 469(c)(7) offers a path for certain taxpayers to overcome this limitation. A taxpayer must first qualify as a “real estate professional” to remove their rental activities from the passive category. Then, they must prove material participation in those activities. To help meet this second requirement, the tax code provides an election to group all rental properties into a single activity, which can allow rental losses to be deducted against all other sources of income.

Qualifying as a Real Estate Professional

To be recognized by the IRS as a real estate professional, a taxpayer must satisfy two tests each year. The first is the “more than half” test, requiring that more than 50% of the individual’s total personal services are in real property trades or businesses. This means time spent on real estate work must exceed time spent on all other employment.

The second requirement is the “750-hour” test, where a taxpayer must perform more than 750 hours of service during the year in real property trades or businesses. For married taxpayers filing a joint return, these tests are applied to each spouse separately. Only one spouse needs to meet both conditions for the couple to benefit from real estate professional status.

The tax code specifies which activities count as “real property trades or businesses.” To meet the qualification tests, a taxpayer’s hours must be in one or more of these areas:

• Development
• Redevelopment
• Construction
• Reconstruction
• Acquisition
• Conversion
• Rental
• Operation
• Management
• Leasing
• Brokerage

Succeeding in these tests requires meticulous record-keeping. Taxpayers must substantiate the hours and nature of their work with documentation like time logs, calendars, appointment books, or narrative summaries. Without adequate proof, the IRS can disallow the professional status and any associated loss deductions.

The Material Participation Requirement

Achieving real estate professional status does not automatically make rental losses deductible. The taxpayer must also prove “material participation” in their rental activities, which is defined as regular, continuous, and substantial involvement. The IRS provides seven tests to determine if this standard is met, and a taxpayer only needs to satisfy one.

The most common tests are based on hours. One is met if the individual participates for more than 500 hours during the year. Another is met if the individual’s participation constitutes substantially all of the participation in the activity by anyone, including non-owners. A third test requires participating for more than 100 hours, provided that no other individual participated more. Other tests examine participation over multiple years or rely on a “facts and circumstances” analysis.

For a real estate professional, the material participation tests are applied to each rental property separately by default. If a taxpayer owns multiple properties, they must demonstrate material participation in each one individually to treat its losses as non-passive. This can be difficult, as meeting a test like the 500-hour rule for each separate rental is often impractical.

Making the Section 469(c)(7) Election to Group Activities

To address the challenge of meeting material participation for each separate property, the tax code allows a real estate professional to make an election to treat all rental real estate interests as one aggregated activity. This election allows them to combine the hours spent on all their properties to meet one of the material participation tests.

For example, if a taxpayer spends 200 hours on Property A, 200 hours on Property B, and 150 hours on Property C, they would fail the 500-hour test for each property. By making the election to group them, they can combine these hours for a total of 550 hours in the single aggregated activity, satisfying the 500-hour material participation test.

This election requires filing a formal statement with a timely filed original tax return for the year the election is to become effective. The IRS does not provide a specific form, so the taxpayer must draft their own statement. The document should state that the taxpayer is a qualifying real estate professional and is making the election to treat all rental real estate interests as a single activity. The statement should include the taxpayer’s name, address, and Social Security number.

Once made, this election is binding for all future years and cannot be easily undone. It applies for the year of the election and all subsequent years, even if there are intermittent years where the taxpayer does not qualify as a real estate professional. Revoking the election is possible only if there is a material change in the taxpayer’s facts and circumstances, which also requires filing a formal statement with the tax return for the year of the change.