The Tax Reform Act (“TRA”) of 1986 brought with it a major revision to the Internal Revenue Code by way of Section 469 with what are known as the “passive loss rules.” The enactment of the passive loss rules changed the rules such that a taxpayer could only deduct losses from a passive activity against income from a passive activity.
Generally, under Section 469 rental activities are treated as per se passive except for specific situations whether or not the taxpayer materially participates. This rule hit individuals that were active in the rental real estate industry especially hard. In response to criticism from those individuals, Congress added Internal Revenue Code Section 469(c)(7) which essentially allows that rental activities of taxpayers in real property trades or businesses (real estate professionals) are not treated as passive if the material participation requirement is satisfied.
Pursuant to Section 469(c)(7), a taxpayer is a real estate professional if (i) the taxpayer owns at least one interest in rental real estate, (ii) more than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates, and (iii) such taxpayer performs more than 750 hours of service during the taxable year in real property trades or business in which the taxpayer materially participates.
With respect to a joint return these requirements are met if and only if either spouse separately satisfies them. The services of the two spouses are not aggregated for purposes of the 750 hour rule. Further, unless the taxpayer makes a special election to aggregate all activities, each rental property is treated separately for purposes of the 750 hour test. Thus, make sure you make the aggregation election to treat them all as one activity.
Breaking down the requirements, a “real property trade or business” is any real estate development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or businesses.
The problem on audit typically involves a taxpayer deducting real estate losses and such taxpayer has another job in addition to the rental real estate activities. In that case, the taxpayer has to spend more than one-half of their personal services in real property trades or businesses. This means they have to spend more time on their real estate activities than they do at their other job. Additionally, they have to meet the 750 hour test in the real property trade or business in which they materially participate. Generally, if those tests cannot be met, a taxpayer’s passive real estate losses are only deductible to the extent of their passive income. Accordingly, a lot of money can be at stake in getting these rules correct.
To prevail in this type of audit the taxpayer’s biggest weapon is, like in all audits, substantiation, substantiation, substantiation. Recently, a taxpayer dentist prevailed against the IRS arguing that he met the requirements to be considered a real estate professional. The case was Zarrinnegar v. Commissioner, TC Memo 2017-034. In this case, the husband taxpayer was a dentist and also operated a real estate brokerage and four rental properties. The taxpayer argued that he spent hundreds of hours on brokerage related activities, including brokers’ showings, listing searches, open houses, property viewings, and client meetings. The taxpayer also spent significant time each year managing his rental properties. In sum, the taxpayer testified he spent over 1,000 hours each year on his real estate business. Conversely, he testified he only worked at the dental practice Mondays, Wednesdays, Thursdays and Fridays from 2:30pm until 6pm, or 14 hours per week. The taxpayer was reporting losses of $221,582, $242,276, and $220,788 (maybe he should have focused more time on the dental practice!).
The Regulations provide that the extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs or similar documents are not required if the extent of such participation can be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
However, post-event ballpark guesstimates are not sufficient pursuant to caselaw.
In prevailing in this case, the taxpayer contemporaneously produced time logs and testified credibly at great length about the logs’ contents; was able to recall extensive details relating to the log entries; and provided the testimony of other credible witnesses. Accordingly, the key was substantiation and having the detail in the logs to credibly testify as to what was done.
Yes, keeping the logs and providing the contemporaneous detail is time consuming and annoying. But, if you are incurring real estate losses, is your time worth more than the amount you are claiming for the losses? Substantiation is the first step to prevailing in the contest is something you control. If you are reporting real estate losses as a real estate professional, make sure you consult with your tax advisor to make sure you have the appropriate substantiation to prevail.
– Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP who concentrates his practice in all manners of Taxation, Real Estate Transactions, Corporate, Partnership and Limited Liability Company law matters. He is a certified specialist in Taxation. Mr. Harrel may be reached at 209-952-4545 or firstname.lastname@example.org.