John Varella, Lourie & Cutler

A recent U.S. District Court ruling may provide helpful assistance in navigating the passive activity loss rules for employees of real estate management companies who also own an interest in the real properties owned and managed by those companies. In Stanley v. U.S., the court was asked to determine whether an employee of a real estate management company who also owned interests in some of the company’s real estate ventures could benefit from an exception to the passive loss limitation rules. Generally, the passive loss rules limit the amount of passive loss that a taxpayer can take to the amount of passive income that the taxpayer has earned for the year.

The renting of real estate is a passive activity. However, the Internal Revenue Code provides an exception to this rule for the rental activities of a qualifying real estate professional. The income and loss from the rental activities of a qualifying real estate professional are not passive income or loss. In order to qualify as a qualifying real estate professional, a taxpayer must (i) perform more than half of his or her personal services in real property trades or businesses in which he or she materially participates, and (ii) he or she must perform more than 750 hours of services during the tax year in real property trades or business in which he or she materially participates.

Generally, the activities of a real estate professional are analyzed on a property-by-property basis. In other words, did the taxpayer meet the above-referenced tests for each property. However, a real estate professional can elect to treat all of his or her ownership interests in rental real estate as one activity and then applies the tests.

Many employees of real estate management companies simply are not aware of the fact that they may qualify as real estate professionals for purposes of avoiding the passive activity loss rules. If an employee of a management company owns 5% or more of the real estate management company, then he or she may qualify as a real estate professional so long as the above-referenced tests are met. Qualifying as a real estate professional could provide a huge tax benefit for taxpayers who would otherwise carry passive losses.

John Varella is an attorney with Lourie & Cutler, Boston, Mass.