Explanation of  Tax code section 469 (c) (7) Investment Real Estate and Section 163 with unlimited deduction 

- by Darci Congrove

In general, rental real estate losses are subject to the passive activity rules, which means that losses can only be used to offset passive income. Certain real estate professionals may be able to treat rental real estate activities as non passive under Code Sec. 469(c)(7).

To qualify:

     (1) more than one-half of the personal services performed in any trade or business by the taxpayer during the tax year must involve real estate trades or businesses in which the taxpayer (or the taxpayer's spouse) materially participates, and

    (2) the taxpayer must perform more than 750 hours of service during the tax year in real estate trades or businesses in which the taxpayer or the taxpayer's spouse materially participates. These two requirements must be satisfied by one spouse if a joint return is filed.

Personal services performed as an employee are not taken into account for purposes of (1) and (2) above unless the employee owns more than a 5% interest in the employer. (i.e. W-2 employees involved in real estate must be owners of the real estate business from which they get the W-2 in order for these hours to be counted as part of the >50% and the >750 hour requirements).

A real property trade or business is defined as a business with respect to which real property is developed or redeveloped, constructed or reconstructed, acquired, converted, rented or leased, operated or managed, or brokered.

The exception for real estate professionals is applied as if each interest of the taxpayer in rental real estate is a separate activity. However, a taxpayer may elect to treat all interests in rental real estate as a single activity for purposes of satisfying the material participation requirements. (This is why we made the election to aggregate all of your real estate interests - when you have several properties, it is physically impossible to meet the 50% and 750-hour standards without aggregating all of the properties together. This is an important point!)

A closely-held corporation qualified as a real estate professional if more than 50% of its annual gross receipts for the tax year are from real property trades or businesses in which it materially participates.

Rental real estate is not subject to the $1,000,000 acquisition indebtedness rule, nor the limitations on deductibility of home equity loans under Code Sec. 163. These rules apply to qualified residence interest only.

A qualified residence includes:

(1) the principal residence of the taxpayer and
(2) one other residence that is not rented out at any time during the tax year, or that is used by the taxpayer for a number of days exceeding the greater of 14 days or 10% of the number of days that it is rented out at a fair rental value.