For taxpayers with rental properties, qualifying as a real estate professional under IRC Section 469(c)(7) is only the first obstacle in avoiding passive activity treatment for rental properties.

Definition of Rental Activity. As a threshold matter, it is important to determine whether an activity is in fact a rental activity for purposes of Section 469.  A rental activity is defined generally as an activity where the gross income from the activity consists of amounts paid principally for the use of property held by the taxpayer in connection with the activity.[i]  In addition to the real estate professional exception to the rule that rental activity is per se passive, there are also exceptions to what is considered a “rental activity.”  If an activity is not considered a rental activity within the meaning of Section 469, the per se passive rule will not apply, allowing the Taxpayer to group the activity with other activities that constitute an appropriate economic unit, making it easier to satisfy the material participation test with respect to the activity.  An activity will not be treated as a “rental activity” if:

  1. The average period of customer use for such property is seven days or less;
  2. The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owners of the property in connection with making the property available for use by customers (the nature of personal service provided is a facts and circumstances determination, with certain exceptions specified in Treasury Regulation Section 1.469-1T(e)(3)(iv)(B));
  3. Extraordinary personal services are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use). Examples provided include a hospital’s boarding facilities, where the rentals are incidental to their receipt of the personal services provided by the hospital’s staff, and the use by students of a schools’ dormitories is generally incidental to their receipt of the personal services provided by the school’s teaching staff.[ii]
  4. The rental of such property is treated as incidental to a non-rental activity of the taxpayer under paragraph (e)(3)(vi) of this section;[iii]
  5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers; or
  6. The provision of the property for use in any activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not rental activity under paragraph (e)(3)(vii).

Special Grouping Rules for Rental Real Estate.  The general rule is that each rental property must be treated as a separate activity.[iv]  However, real estate professionals have the option of grouping all of their rental properties together as a single activity under the regulations setting forth rules for certain rental real estate activities (Treasury Regulation Section 1.469-9).[v]  For a taxpayer who has many rental properties, it may be difficult if not impossible for the taxpayer to satisfy the material participation tests with respect to each and every rental property, even if he works full time in the rental real estate business.  The election allows taxpayers to treat their rental activities as a single activity, though taxpayers are still precluded from grouping their interests in rental property with other activities in the real estate industry or other activities that would create an appropriate economic unit.

While making the election could allow taxpayers with multiple rental properties to be able to deduct their losses on an annual basis, taxpayers must consider before making the election the potential consequences of such an election. In particular, if the taxpayer has suspended losses from rental activities despite grouping all of the real estate properties, the election presents a drawback for the taxpayer—if the taxpayer disposes of his interest in one of the rental properties that had a suspended loss, that loss will continue to be suspended until the taxpayer has disposed of all of his rental properties which he had elected to group together as a single activity.

Making an Election to Group Rental Activities. An election to treat all of a taxpayer’s interests in rental real estate as a single rental real estate activity can be made by the taxpayer in any year in which he is a qualified taxpayer (that is, meets the requirements to be considered a real estate professional under Section 469(c)(7)), and the election will be binding for the taxable year in which it is made and for all future years in which the taxpayer is a qualifying taxpayer, even if there are intervening years where the taxpayer does not qualify.[vi] The election may be made during any year in which the taxpayer is eligible.

The election is made by filing a statement with the taxpayer’s original income tax return for the taxable year that contains a declaration that the taxpayer is a qualifying taxpayer for the taxable year and is making the election pursuant to Section 469(c)(7)(A).[vii]

The election can be revoked only by a showing of a material change in the taxpayer’s facts and circumstances. To revoke an election, the taxpayer must file a statement with the taxpayer’s original income tax return for the year of revocation, containing a declaration that the taxpayer is revoking the election under Section 469(c)(7)(A) and an explanation of the nature of the material.[viii]

Satisfying One of the Material Participation Tests. Even if owners of rental real estate have elected to group their real estate activities as one activity, there are still challenges in satisfying the material participation tests.  The taxpayer is limited to considering only the real estate professional’s hours spent on the rental activity and cannot consider the taxpayer’s other hours spent working for the taxpayer’s other real estate business(es).  Moreover, the significant participation activity test—which taxpayers often rely on when they have multiple different activities that may not exceed 500 hours—is not available to taxpayers trying to satisfy the material participation test with respect to their interest in rental real estate.  A significant participation activity is defined in pertinent part by reference to a “trade or business…other than rental activities…,” specifically excluding rental activities from qualifying for the significant participation activity material participation test.[ix]  When applying the material participation tests to a rental activity, it is important to ensure that the material participation test being considered applies to the taxpayer’s facts and circumstances and takes into account only those hours spent participating in the rental activity.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] See Treas. Reg. § 1.469-1T(e)(3).

[ii] Treas. Reg. § 1.469-1T(e)(3)(v).

[iii] Requirements for this exception are set forth in Treas. Reg. § 1.469(e)(3)(vi).

[iv] Treas. Reg. § 1.469-9(e).

[v] Treas. Reg. § 1.469-9(g).

[vi] Treas. Reg. § 1.469-9(g)(1).  The election will not apply in any year where the taxpayer is not a qualifying taxpayer.

[vii] Treas. Reg. § 1.469-9(g)(3).

[viii] Id.

[ix] See Treas. Reg. § 1.469-5T(c)(1)(i) (a significant participation activity is a trade or business activity “within the meaning of § 1.469-1T(e)(2)….”); § 1.469-1T(e)(2) (refers to § 1.469-1(e)(2)); § 1.469-1(e)(2) (“Trade or business activities are activities that constitute trade or business activities within the meaning of § 1.469-4(b)(1); § 1.469-4(b)(1) (“Trade or business activities are activities, other than rental activities….”).

The dominoes continue to fall from last year’s Supreme Court reversal of former Virginia governor Bob McDonnell’s conviction for honest services fraud, for his having set up meetings in exchange for money. On July 12, 2017, the Second Circuit reversed a politician’s convictions for honest services fraud and money laundering because the jury instruction ran afoul of the Supreme Court’s McDonnell decision. United States v. Silver, No. 16-1615-cr.  This decision highlights the difference between law and morality – what we expect from our public figures isn’t the same as what the law requires them to do.

Unlike term-limited California, New York allows its Assembly members to serve forever. That system permitted Sheldon Silver, a 20-year Speaker of the Assembly, to become “the most powerful man in New York,” according to a witness in his criminal trial.  Unscrupulous businesspersons were willing to pay for this influence, and Silver was willing to sell it.  Silver was indicted for committing honest services fraud, primarily for his having engaged in a string of actions that benefitted persons who were generating business for his part-time law practice.  The most-egregious actions occurred outside the statute of limitations period, so the government’s case rested on proving that the last few actions – including obtaining Assembly accolades for one of Silver’s co-conspirators – constituted illegal conduct.  Silver caught a big break when the trial judge accepted the government’s “honest services fraud” jury instruction, which defined the fraud as involving “any action” by a politician undertaken in exchange for something of value.  The jury convicted Silver based on this broad language, but the Second Circuit decided that the language was too broad under the later-decided McDonnell because it allowed the jury to convict based on setting up meetings or performing other tasks that non-politicians can perform.  The Supreme Court limited honest services fraud to actions that only politicians can take, such as voting on legislation, instead of more-subtle exercises of power such as introducing people to each other.  Because the final few alleged criminal actions weren’t obviously illegal, the government couldn’t show that the erroneous jury instruction was harmless beyond a reasonable doubt.  Mr. Silver will get a new trial with a jury instruction consistent with McDonnell, although the evidence will be unchanged and the optics of his earlier actions – steering public funds to his co-conspirators in exchange for referral fees – remain difficult for Silver to overcome.

What does this mean for white-collar criminal defendants? The Supreme Court is requiring that prosecutors and judges be precise and not rely on bringing charges and making arguments before juries that test the outer boundaries of amorphous crimes and statutes.  Appellate courts have taken notice and are no longer turning a blind eye to unreasonably broad interpretations of criminal statutes. 

What does this mean for tax cases? The Second Circuit’s Silver decision confirms that appellate courts got the Supreme Court’s message and that McDonnell’s legacy will continue to grow.  The McDonnell case may be a gift that keeps on giving for tax defendants, particularly those charged with a violation of 26 U.S.C. Section 7212, which prohibits the interference with IRS functions and has long been an example of a troublingly broad criminal statute.  The Supreme Court recently agreed to review a Section 7212 conviction, Carlos Marinello, II, v. United States, to determine whether the statute, at least as applied to Marinello’s actions and inactions such as not maintaining books and records, runs afoul of the U.S. Constitution.  DOJ can’t be happy about the Supreme Court’s decision to grant certiorari in Marinello, a case that DOJ won.

Although Silver isn’t the sort of person who would earn my vote, his unseemly political actions don’t obviously equal criminal actions simply because they fall short of what we expect of our elected officials. Fortunately, appellate courts generally know the difference between moral corruption and criminal actions.

EVAN J. DAVIS – For more information please contact Evan Davis – davis@taxlitigator.com or 310.281.3288. Mr. Davis is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) handling civil and criminal tax cases and, subsequently, of the Major Frauds Section of the Criminal Division of the Office of the U.S. Attorney (C.D. Cal) handling white-collar, tax, and other fraud cases through jury trial and appeal. He has served as the Bankruptcy Fraud coordinator, Financial Institution Fraud Coordinator, and Securities Fraud coordinator for the USAO’s Criminal Division, and the U.S. Attorney General awarded him the Distinguished Service Award for his work on the $16 Billion RMBS settlement with Bank of America.

Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, and federal and state white collar criminal investigations. He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (OVDP, Streamlined Procedures and otherwise).

Posted by: jkalinski | October 6, 2017

FOR WHOM THE COLLECTION STATUTE TOLLS by Jonathan Kalinski

Every tax practitioner knows the general rule that the IRS has 10 years to collect a tax after the assessment. That isn’t blog material.  Less well known because it is infrequently litigated, is the flush language of IRC §6502(a), which states that the collection statute of limitations is tolled if a timely proceeding in court is commenced when the collection statute is open.  As a result, the government can collect after the 10-year period has expired.

That brings us to a recent Michigan District Court[1] case filed by the government to reduce the liability to judgment that focused on what constitutes a proceeding in court.  The facts are this: In 2005 the IRS timely assessed a 2002 liability against Albert Chicorel, who subsequently died in 2006.  The IRS sent a proof of claim to the estate’s representative and filed it with the Oakland County Probate Court.  The proof of claim was docketed and never disputed.  Mr. Chicorel’s probate case is still pending.  The estate argued that the collection statue expired because 10 years from assessment had passed.  The estate lost.

The parties agreed the issue was a question of Federal law that turned on the nature, function, and effect of submitting a probate claim under local law. The Court held that the “nature, function, and effect” of the proof of claim constituted a proceeding in court and tolled the limitations period.  In doing so it did not rely on Federal tax law, but likened the case to ERISA, SEC, and Title VII precedents.  Michigan’s probate statute provides that for purposes of a statute of limitations, the proper presentation of a claim…is the equivalent to commencement of a proceeding on the claim.

It is important to note that in California and Massachusetts the decision likely would have been different. In United States v. Silverman[2], the Ninth Circuit held that the filing of a claim in California Probate Court did not constitute a proceeding before that court because it would undermine a state statute of limitations.  In United States v. Saxe[3], the First Circuit held that a proof of claim did not commence an actual proceeding, but served to extend the time for service of process in an action already commenced.

In New York, Illinois, and Kentucky, the decision would have been the same. This illustrates the importance of checking state law where relevant, and not simply relying on a Federal case.

Although the decision is bad news for taxpayers in Michigan, there is a potential silver lining. The government is generally hesitant to file a proof of claim because doing so can allow the taxpayer to challenge the liability.    In this case the estate never challenged the claim.

Jonathan Kalinski a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and specializes in both civil and criminal tax controversies as well as sensitive tax matters including disclosures of previously undeclared interests in foreign financial accounts and assets and provides tax advice to taxpayers and their advisors throughout the world.  He handles both Federal and state tax matters involving individuals, corporations, partnerships, limited liability companies, and trusts and estates. He routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions.

Mr. Kalinski has considerable experience handling complex civil tax examinations, administrative appeals, and tax collection matters.  Prior to joining the firm, he served as a trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising Revenue Agents and Revenue Officers on a variety of complex tax matters.  Jonathan Kalinski also previously served as an Attorney-Adviser to the Honorable Juan F. Vasquez of the United States Tax Court.

Mr. Kalinski can be contacted at kalinski@taxlitigator.com. Additional information is available at http://www.taxlitigator.com.

[1] United States v. Estate of Albert Chicorel, Eastern District of Michigan, Case No. 16-10894.

[2] United States v. Silverman, 621 F.2d 961 (9th Cir. 1980), cert. denied, 450 U.S. 913 (1981).

[3] United States v. Saxe, 261 F.2d 316, 319 (1st Cir. 1958).

Posted by: Steven Toscher | September 28, 2017

Evan Davis and I recently published an article you may find of interest for the 2017 USC Tax Institute entitled ” 30 Years After- What the Federal Sentencing Guidelines Have Meant for Criminal Tax Enforcement. Here is the link https://lnkd.in/gssJch2

Posted by: Steven Toscher | September 26, 2017

CRIMINAL TAX ENFORCEMENT— IT HAPPENED AGAIN AND WE SHOULD NOT BE SURPRISED by Steven Toscher ©2017

The Treasury Inspector General for Tax Administration (“TIGTA”) issued a report September 13, 2017, concluding that “declining resources have contributed to unfavorable trends in criminal investigation business results.” That’s Government speak that the IRS criminal tax enforcement program is falling behind.

This is not a surprise for those of us in the trenches.  It reminds us of another report issued almost 20 years ago, the so-called “Webster Report” issued in 1999, in which an independent review by former FBI and CIA Director William Webster concluded the IRS Criminal Investigation Division had suffered “mission drift” and that its lack of investigations of income tax fraud would have a negative impact on taxpayer compliance.

When the Webster Report was issued, the mission drift was a function of IRS devoting too many resources toward drug enforcement.   Today the  mission drift is more due to shrinking government resources and a focus on taxpayer identity theft by the Criminal Investigation Division.

The point is that if we are going to have an IRS criminal investigation function that serves as a deterrent against taxpayers committing tax crimes, the TIGTA Report is alarming on a number of counts.

Most strikingly, for fiscal year 2016, the Criminal Investigation Division (“CI”) initiated 3,395 cases or an overall decrease of 44%, compared to 5,125 cases initiated in fiscal year 2012.  That’s a big drop.

The other important statistic is that the percentage of cases initiated from functions within the IRS (the examination function and collection function), has decreased 5% from fiscal 2012 to 2016.   One of the key takeaways from the Webster Report was to increase the “fraud referral program” which in fact was reinvigorated post-Webster Report; however, that reinvigoration seems to have lost steam– likely due to  budget constraints within the  IRS operating divisions.

Finally, the other key takeaway is that in fiscal year 2016, it took an average of 540 days or 1.5 years to determine  there was no prosecution potential in a case.  In 2012, it only took an average of 422 days to make that determination.

The TIGTA Report is a good read for anybody interested in tax enforcement and it raises the fundamental question of whether we are serious in a vibrant and effective criminal tax enforcement program.  After all, with a $458 billion tax gap—even a one (1%) percentage point uptick in taxpayer compliance translates  to  almost $5 billion of additional revenue.  Under CI’s current budget of $576 million, that could be very good return on investment.

Taxpayers in Real Property Business. Although the general rule is that all rental activities are by definition passive, the Code has created an exception for certain professionals in the real estate business.  A real estate professional (as that term is defined under Section 469(c)(7), the section that sets forth the exception to the rule that all rental activities are per se passive) is defined as a taxpayer who (1) spends more than 750 hours in the tax year working in a real property trade or businesses in which he materially participates and (2) performs more than one-half of his personal services during the tax year for real property trades or businesses.[i]

Definition of a real property trade or business. A “real property trade or business” is defined to include “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”[ii]  Although this list is quite comprehensive, it is important to note that the definition of a real property business does not explicitly include real estate financing.  In a recently issued Tax Court Summary Opinion, Hickam v. Commissioner (TC Summary Opinion 2017-66, August 17, 2017)[iii], the Tax Court held that a taxpayer who brokered real estate mortgages and originated residential and commercial loans was not a real estate professional within the meaning of Section 469(c)(7), because the taxpayer’s mortgage brokerage and loan origination businesses were not real property trade or business as defined in Section 469(c)(7)(C).  The Tax Court concluded that although the loans he brokered and originated were secured by real property, his mortgage brokerage services and his loan origination services did not involve operating the real properties that secured those loans—although he had a “brokerage” trade or business, it was not a “real property brokerage.”

Qualifying as a Real Estate Professional. In determining whether a taxpayer qualifies as a real estate professional, the only hours that count towards the real estate professional test are those in which the taxpayer has an interest and materially participates.  Services performed for a real estate business as an employee generally do not count for qualifying as a real estate professional, unless the taxpayer is at least a 5% owner of the employer.  In the case of taxpayers filing a joint return, spouses may not combine their hours to satisfy these requirements.[iv]  This differs from the rules applicable to satisfying the material participation rules, which allow spouses to combine hours worked.

If a taxpayer qualifies as a real estate professional, he avoids the per se passive rule for rental activities.  However, he will still have to satisfy the material participation tests (subject to additional limitations applicable to rental activities), in order to establish that the rental activity is a non-passive activity for purposes of Section 469.  These obstacles include prohibiting rental activities from being grouped with other real estate-related undertakings in applying the material participation tests, and prohibit a taxpayer from grouping his rental real estate activities together as a single activity, unless the taxpayer affirmatively makes an election to do so.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] IRC § 469(c)(7)(B).

[ii] IRC § 469(c)(7)(C).

[iii] Hickam v. Commissioner, Docket No. 3901-16S (TC Summary Opinion 2017-66, August 17, 2017), available here: http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11368.

[iv] However, note that in satisfying the material participation test for purposes of determining whether an activity is a passive activity, hours contributed by the spouse may be included in the number of hours of participation by the taxpayer in the activity.

Determining a Taxpayer’s “Activity.” A taxpayer’s trade or business undertakings can be combined to form an “activity” for purposes of applying the material participation rules if the undertakings “form an appropriate economic unit for measuring gain or loss under the passive activity rules,” considering all relevant facts and circumstances.[i]  Taxpayers have the freedom to group their business undertakings (including those conducted through S corporations and partnerships) in accordance with the rules of Treasury Regulation § 1.469-4 using any reasonable method.  An example of this flexibility is provided in the regulations, which state:

“Example (1). Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C’s activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities.”[ii]

As the above example demonstrates, a movie theater business and a bakery business can constitute an appropriate economic unit, simply on the basis that they are located in the same city. Similarity of businesses is also a reasonable method of grouping activities, even if the businesses are operated in different cities.  The following factors are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469: (1) similarities and differences in types of trades or businesses; (2) the extent of common control; (3) the extent of common ownership; (4) geographical location; and (5) interdependencies between or among the activities.[iii]

The material participation test is applied to work performed by the taxpayer in connection with the “activity,” so a broad grouping makes it easier to meet the material participation test because the taxpayer’s time is split between fewer activities. However, there are other considerations that should be taken into account when deciding whether to group multiple activities.  In particular, if the activity has losses being suspended into future tax  years, those losses cannot be deducted on the taxpayer’s return until all of the taxpayer’s interest in the activity has been disposed of.

Once a taxpayer determines which of his businesses are appropriately grouped, the taxpayer may not change how he has grouped these real property trades or businesses in subsequent taxable years unless the original determination was clearly inappropriate or there has been a material change in the facts and circumstances that makes the original determination clearly inappropriate.[iv]

Although taxpayers have freedom in grouping their undertakings however they wish as long as the method used in reasonable, for tax years after January 24 2010, certain disclosures are required for a taxpayer’s grouping. Taxpayers are required to report to the IRS: (1) changes to a taxpayer’s groupings during the tax year; (2) a new grouping; (3) or an addition to an existing grouping.[v]  Disclosures of new groups must be made on a written statement filed with the taxpayer’s written return, providing the names, addresses, and EINs, if applicable, for the activities being grouped as a single activity. The statement must also include a declaration that the grouped activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules.[vi]

Material Participation Tests. There are seven tests for material participation, set forth in Treasury Regulation § 1.469-5T—if any one of these tests is satisfied, the activity will be considered to be active, allowing the taxpayer to avoid the loss limitation rules:[vii]

1)            Participated in the activity for more than 500 hours (a bright line test);

2)            The taxpayer’s participation was substantially all the participation in the activity of all individuals for the tax year (including employees);

3)            The taxpayer participated in the activity for more than 100 hours during the tax year, and the taxpayer participated at least as much as any other individual (including employees) for the year;

4)            The activity is a significant participation activity, and the taxpayer participated in all significant participation activities for more than 500 hours.  A significant participation activity is an activity in which the taxpayer performs more than 100 hours of services during the year and no other material participation test applies;[viii]

5)            Materially participated for any 5 of the 10 immediately preceding tax years;

6)            The activity is a personal service activity and the taxpayer materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year;[ix] or

7)            Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis during the year (applicable only if the taxpayer worked at least 100 hours in connection with the activity).  This test is not frequently satisfied and there are limitations to when hours spent by an individual in managing an activity can be counted for purposes of satisfying the 100-hour minimum requirement.[x]

Proving Material Participation. The extent of an individual’s participation in an activity may be established by any reasonable means.  Contemporaneous daily time repots, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means.  Reasonable means include, but are not limited to, the identification of services performed over a period of time and of the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.[xi]  The regulations do not allow a post-event “ballpark guesstimate.”[xii]

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

[i] Treas. Reg. ‘ 1.469-4(c)(1).  As previously noted in this series, there is an exception to the grouping rules for rental activities, which generally cannot be grouped with a non-rental trade or business.  The exception to this rule will be explored later in this series.

[ii] Treas. Reg. 1.469-4(c)(3)(Example 1).

[iii] Treas. Reg. ‘ 1.469-4(c)(2).

[iv] https://www.irs.gov/pub/irs-pdf/p925.pdf at p. 9.

[v] Id.

[vi] Id.

[vii] Treas. Reg. § 1.469-5T(a).  Section 1.469-5T(f) sets forth certain limitations on what services by an owner can be considered for purposes of the material participation rules, including certain management activities.  However, taxpayers may count as participation hours worked by their spouse.

[viii] This rule means that to qualify as a significant participation activity, the taxpayer must perform more than 100 hours but fewer than 500 hours.  This can create some peculiar results.  For example, if a Taxpayer has an interest in Activity A, Activity B, and Activity C, and spends 150 hours in Activity A, 250 hours in Activity B, and 499 hours in Activity C, then the taxpayer will be treated as having materially participated in all three activities.  However, if the taxpayer instead worked 501 hours in Activity C, then the taxpayer will be treated as materially participating in only Activity C, because Activity C is no longer a significant participation activity because it now satisfies one of the other material participation tests, and Activities B and C combined do not exceed the necessary 500 hour threshold.

[ix] See Treas. Reg. § 1.469-T(d).

[x] Treas. Reg. § 1.469-5T(b)(1)(ii).

[xi] Treas. Reg. § 1.469-5T(f)(4).

[xii] Bailey v. Comm’r, T.C. Memo 2001-296.

Questions relating to the Internal Revenue Code’s material participation rules for losses frequently arise in the context of real estate businesses, where losses are common as a result of depreciation deductions and deductions for other costs incurred by the owner. This series will provide the fundamentals of the material participation rules as they relate to the real estate industry and will highlight intricacies and exceptions in the rules that tax professionals and taxpayers in the real estate industry should be attuned to.

Overview of Section 469. Section 469 of the Internal Revenue Code generally disallows taxpayers from using a loss incurred in a taxable year from a “passive activity” to offset ordinary income on their income tax returns.[i]  These losses are suspended and will be treated as a loss from that activity incurred in the subsequent taxable year.[ii]  Passive losses will remain suspended until there is either (1) income from a passive activity in a subsequent year that can offset the loss,[iii] or (2) until the taxpayer disposes of his entire interest in the activity, at which time all suspended passive losses from that activity can be deducted.[iv]  The Code’s passive loss rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations.[v]

Definition of Passive Activity. A passive activity is defined generally as any activity which involves the conduct of any trade or business and in which the taxpayer does not “materially participate.”[vi]   However, notwithstanding this general definition, Section 469 specifies that any rental activity will be treated as a passive activity, regardless of whether the taxpayer materially participated in the rental activity.  This makes rental activities per se passive, requiring all losses from rental activities to be suspended.

Treatment of Rental Real Estate. The Code carves out one exception to the rule that “passive activity” by definition includes any rental activity for certain taxpayers in the real property business (generally referred to as a real estate professional).  If a taxpayer satisfies the requirements of Section 469(c)(7) to qualify as a real estate professional,[vii] the rule that all rental activities are passive does not apply.[viii]  However, even if a taxpayer qualifies as a real estate professional within the meaning of Section 469(c)(7), that doesn’t mean the taxpayer’s losses from real estate rental activities will automatically become deductible.  The taxpayer must still prove that the rental activity is not a passive activity under the general rule, with additional limitations that apply that make it more difficult to satisfy the material participation requirement.[ix]

Section 469 also allows a limited $25,000 offset for losses from rental real estate activities for certain taxpayers who are natural persons, actively participated in the rental activity, and who satisfy the income requirements.[x]

Treatment of Other Real Estate Businesses. These limitations to deducting losses from rental real estate activities do not apply to other trades and businesses in the real estate industry.  For example, taxpayers who have an interest in a construction business or a real estate development business are subject to the general definition of a passive activity, which treats the activity as non-passive (thereby making the losses deductible), if the taxpayer materially participated in the activity.[xi]

The passive loss rules do not apply to taxpayers who are simply holding real property for investment—gain or losses incurred by a taxpayer from the disposition of real property that had been held for investment are instead subject the Code’s capital gain/loss rules.[xii]  However, regardless of a taxpayer’s investment intent, an interest in a rental property is not treated as property held for investment for purposes of the passive loss limitation rules.[xiii]

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

[i] IRC § 469(a)(1).

[ii] IRC § 469(b).

[iii] The term “passive activity loss” for purposes of the Section 469 loss disallowance rules is defined as the amount by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year.  IRC § 469(d)(1).

[iv] IRC § 469(g).

[v] IRC § 469(a)(2).

[vi] IRC § 469(c)(1).

[vii] IRC § 469(c)7)(B), (C).

[viii] IRC § 469(c)(7)(A).

[ix] See Treas. Reg. § 1.469-9(e).

[x] IRC § 469(i).

[xi] See Treas. Reg. § 1.469-5T for the material participation tests.

[xii] IRC § 469(e)(1)(A)(ii); § 1221.

[xiii] IRC § 469(e)(1) (the flush language under § 469(e)(1) states that “any interest in a passive activity shall not be treated as property held for investment”).

The Financial Crimes Enforcement Network (FinCEN) just announced the issuance of revised Geographic Targeting Orders (GTOs) that require U.S. title insurance companies to identify the natural persons behind shell companies used to purchase for high-end residential real estate in seven metropolitan areas for the period September 22, 2017 to March 20, 2018. Following the recent enactment of the Countering America’s Adversaries through Sanctions Act, FinCEN has revised their previously issued GTOs to capture a broader range of transactions, include transactions involving wire transfers and expanded the GTOs to include transactions conducted in the City and County of Honolulu, Hawaii.

THE GTO’s – U.S. title insurance companies are now required to report to FinCEN by filing a FinCEN Form 8300 within 30 days of the closing of the Covered Transaction. Each FinCEN Form 8300 filed pursuant to the GTO must be: (i) completed in accordance with the terms of this GTO and the FinCEN Form 8300 instructions (when such terms conflict, the terms of the GTO apply), and (ii) e-filed through the Bank Secrecy Act E-filing system. Further, they must: (1) retain all records relating to compliance with the GTO for a period of five years from the last day that the GTO is effective (including any renewals of the GTO); (2) store such records in a manner accessible within a reasonable period of time; and (3) make such records available to FinCEN or any other appropriate law enforcement or regulatory agency, upon request.

ADVISORY – In addition, FinCEN published an Advisory to provide financial institutions and the real estate industry with information on the money laundering risks associated with real estate transactions, including those involving luxury property purchased through shell companies, particularly when conducted without traditional financing. The Advisory provides information on how to detect and report these transactions to FinCEN.

In January 2016, FinCEN issued GTOs to require U.S. title insurance companies to report beneficial ownership information on legal entities, including shell companies, used to purchase certain luxury residential real estate in Manhattan and Miami—specifically, luxury residential property purchased by a shell company without a bank loan and made at least in part using a cashier’s check or similar instrument.  In July 2016 and February 2017, FinCEN reissued the original GTOs and extended coverage to all boroughs of New York City, two additional counties in the Miami metropolitan area, five counties in California (including Los Angeles, San Francisco, and San Diego), and the Texas county that includes San Antonio.

TRANSACTIONS COVERED BY THE GTO’s – The GTOs identify a Covered Transaction as a transaction in which: (a) a Legal Entity (generally a corporation, limited liability company, partnership or other similar business entity, whether formed under the laws of a state or of the United States or a foreign jurisdiction), (b) purchases residential real property, (c) without a bank loan or other similar form of external financing, (d) such purchase is made, at least in part, using currency or a cashier’s check, a certified check, a traveler’s check, a personal check, a business check, or a money order in any form, or a funds transfer, and (e) the total purchase price is (i) $2,000,000 or more in the California county of San Diego, Los Angeles, San Francisco, San Mateo, or Santa Clara, (ii) $3,000,000 or more in the City and County of Honolulu in Hawaii, (iii) $3,000,000 or more in the Borough of Manhattan in New York City, New York, (iv) $1,500,000 or more in the Borough of Brooklyn, Queens, Bronx, or Staten Island in New York City, New York, (v) $1,000,000 or more in the Florida county of Miami-Dade, Broward, or Palm Beach, and (vi) $500,000 or more in the Texas county of Bexar.

The GTOs require a Covered Business to collect and report certain identifying information about the Beneficial Owner(s) of the Purchaser in a Covered Transaction. For purposes of the GTOs, a “Beneficial Owner” means each individual who, directly or indirectly, owns 25% or more of the equity interests of the Purchaser. The GTOs provide that the Covered Business must obtain and record a copy of the Beneficial Owner’s driver’s license, passport, or other similar identifying documentation. The Covered Business may reasonably rely on the information provided to it by third parties involved in the Covered Transaction, including the Purchaser or its representatives, in determining whether the individual identified as a Beneficial Owner is in fact a Beneficial Owner

SUSPICIOUS ACTIVITY REPORTS – Within the scope of real estate transactions covered by the GTOs, FinCEN data indicate that about 30 percent of reported transactions involve a beneficial owner or purchaser representative that was also the subject of a previous suspicious activity report. A covered financial institution is required to file a SAR if it knows, suspects, or has reason to suspect a transaction conducted or attempted by, at, or through the financial institution involves funds derived from: illegal activity, attempts to disguise funds derived from illegal activity, is designed to evade regulations promulgated under the BSA, lacks a business or apparent lawful purpose, or involves the use of the financial institution to facilitate criminal activity. According to FinCEN, beneficial owners or purchaser representatives in a significant portion of transactions reported under the GTO had been previously connected to a wide array of suspicious activities, including:

  • A beneficial owner suspected of being connected to over $140 million in suspicious financial activity since 2009 and who sought to disguise true ownership of related accounts.
  • Two beneficial owners (husband and wife) involved in a $6 million purchase of two condominiums were named in nine SARs filed from 2013 – 2016 in connection with allegations of corruption and bribery associated with South American government contracts.
  • A beneficial owner suspected of being connected to a network of individuals and shell companies that received over $6 million in wire transfers with no clear business purpose from entities in South America. Much of these funds were used for payments to various real estate related businesses.
  • Eleven SARs filed from 2008 through 2015 named either the buyer (an LLC), beneficial owner, or purchaser’s representative involved in a GTO-reported $4 million purchase of a residential unit. Law enforcement records indicate that both the purchaser’s representative and his business associate were associated with a foreign criminal organization involved in narcotics smuggling, money laundering, health care fraud, and the illegal export of automobiles.

FORM 8300 DUE WITHIN 30 DAYS – If the Covered Business is involved in a Covered Transaction, then the Covered Business shall report the Covered Transaction to FinCEN by filing a FinCEN Form 8300 within 30 days of the closing of the Covered Transaction. Each FinCEN Form 8300 filed pursuant to this Order must be: (i) completed in accordance with the terms of this Order and the FinCEN Form 8300 instructions (when such terms conflict, the terms of this Order apply), and (ii) e-filed through the Bank Secrecy Act E-filing system.

FinCEN is concerned about this small segment of the market in which shell companies are used to buy luxury real estate in “all-cash” transactions. In addition, feedback from law enforcement to FinCen apparently indicates that the reporting has advanced criminal investigations.  FinCEN believes the expanded GTOs will further help law enforcement and inform FinCEN’s future efforts to assess and combat the money laundering risks associated with luxury residential real estate purchases.

Additional information is available at:

FinCEN Targets Shell Companies Purchasing Luxury Properties in Seven Major Metropolitan Areas

https://www.fincen.gov/news/news-releases/fincen-targets-shell-companies-purchasing-luxury-properties-seven-major

Advisory to Financial Institutions and Real Estate Firms and Professionals (FIN-2017-A003)

https://www.fincen.gov/sites/default/files/shared/Real%20Estate%20GTO%20Order%20-%208.22.17%20Final%20for%20execution%20-%20Generic.pdf

FinCEN Geographical Targeting Order (GTO) dated August 22, 2017

https://www.fincen.gov/sites/default/files/advisory/2017-08-22/Risk%20in%20Real%20Estate%20Advisory_FINAL%20508%20Tuesday%20%28002%29.pdf

FinCEN Frequently Asked Questions re Geographical Targeting Order (GTO) dated August 22, 2017

https://www.fincen.gov/sites/default/files/shared/FAQs%20on%20Phase%204%20Real%20Estate%20GTO%208.22.2017%20FINAL.pdf

CHARLES RETTIG – Chuck Rettig is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., specializing in civil and criminal tax controversies as well as tax, business and estate planning, and family wealth transfers. Listed as the only Eminent Practitioner by Chambers USA specializing in “Tax: Fraud – Nationwide, Chuck is internationally recognized for his expertise in the representation of US Persons having undeclared interests in foreign financial accounts and assets, including sensitive civil examinations, IRS voluntary disclosure programs and procedures. Mr. Rettig is a Certified Specialist both in Taxation Law and in Estate Planning, Trust & Probate Law by the State Bar of California, Board of Legal Specialization and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com For more information please contact Chuck Rettig directly – rettig@taxlitigator.com

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