A “real estate professional” may treat rental real estate activities as non-passive if the taxpayer “materially participates” in the rental activities. Taxpayers claiming to be a real estate professional should contemporaneously document their efforts with respect to each real estate activity.
A taxpayer is generally allowed deductions for certain business and profit-seeking investment expenses. However, Code Section 469 disallows a taxpayer’s deductions attributable to a passive activity loss for the taxable year. Section 469(d)(1) defines “passive activity loss” as “the amount (if any) by which — (A) the aggregate losses from all passive activities for the taxable year, exceed (B) the aggregate income from all passive activities for such year.”
REAL ESTATE PROFESSIONAL. Passive activity is defined as any activity “which involves the conduct of any trade or business, and * * * in which the taxpayer does not materially participate.” The Code specifically provides that the term “passive activity” also includes any rental activity. Code Sec. 469(c)(7) then provides an exception from that rule for the rental real estate activity of a taxpayer who is engaged in a real property trade or business (a “real estate professional”).
A taxpayer qualifies as a real estate professional under Code Sec. 469(c)(7)(B)(i) and (ii) if:
(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. This list does not include any research or other preparatory activities.
Unless the taxpayer timely elects otherwise, the taxpayer must satisfy the requirement of material participation as applied separately to each rental real estate interest. In the case of a joint return, the foregoing requirements of Code Sec. 469(c)(7)(B)(i) and (ii) are satisfied if and only if either spouse separately satisfies such requirements.
The Treasury 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 may be established by other reasonable means. Reasonable means * * * 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.
“BALLPARK GUESSTIMATE” INSUFFICIENT. Although “reasonable means” may be interpreted broadly, “a post event ‘ballpark guesstimate'” will not suffice. In Almquist v. Commissioner, T.C. Memo. 2014-40 (March 10, 2014), Tax Court Judge Wherry sustained an accuracy-related penalty and held that a couple was not entitled to claim losses related to the rental of two real estate properties, finding that the husband didn’t qualify as a real estate professional and the passive activity loss limitation rule of Code Section 469 applied.
To support the taxpayer husband’s material participation, at the beginning of the IRS audit, the taxpayers created a calendar from very brief cryptic notes in the husband’s personal spiral notebook daily records. The calendar was created about a year after the fact, long after the asserted work was completed. No documents or emails supporting the calendar entries were provided to the Tax Court. The calendar entries were only supported by the taxpayers “self-serving testimony.”
Judge Wherry held that the Tax Court was not required to accept such “self-serving testimony” and is not willing to rely on testimony alone to establish the status of the taxpayer husband as having satisfied the material participation requirements necessary to qualify as a “real estate professional.” Without any supporting documentation, the Tax Court held that the calendar created over a year after the work was completed was nothing more than “a post event ‘ballpark guesstimate'”.
Accordingly, the taxpayers’ rental real estate activity was treated as passive and the claimed deductions relating to the passive activity losses was disallowed for the tax year at issue. The disallowed deduction is “treated as a deduction or credit allocable to such activity in the next taxable year.”
ACCURACY-RELATED PENALTY APPLIED. The Tax Court upheld the government’s assertion of a Code Section 6662(a) accuracy-related penalty equal to 20% of the underpayment of tax. The penalty is applicable with respect to adjustments attributable to negligence or, alternatively, because the underpayment is due to a substantial understatement of income tax. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code, including any failure to keep adequate books and records or to substantiate items properly. A substantial understatement is an understatement of income tax that exceeds the greater of 10% of the tax required to be shown on the return or $ 5,000.
Reliance on the advice of a tax professional may, but does not necessarily, establish reasonable cause and good faith for the purpose of avoiding a section 6662(a) penalty. To avoid liability for a Code Section 6662(a) penalty on the basis of reliance on a tax professional, a taxpayer must meet the following three requirements: “(1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment.”
The fact that the taxpayers in Almquist had an accountant prepare their returns does not, in and of itself, prove that they acted with reasonable cause and in good faith. Additionally, the tax Court noted that the taxpayers’ failure to properly document their time spent performing rental activities made it impossible for their accountant to have all the accurate information necessary to make an informed tax decision. The accountant relied on the taxpayers for an accurate representation of the amount of hours worked on their rental activity; however, the taxpayers were unable to prove the purported hours worked. Accordingly, the Tax Court concluded that the taxpayers were liable for the Code Section 6662 accuracy-related penalty.
IRS AUDIT TECHNIQUE GUIDE. The IRS is aggressively examining returns claiming status as a “real estate professional.” To assist IRS agents examining the real estate professional issue, the IRS has published an Audit Technique Guide regarding Passive Activity Losses. The ATG provides a summary of court cases, checklists for common issues, various decision trees and references the following common IRS examination techniques:
- Determine whether the taxpayer materially participates in one or more of the specific real estate trades or businesses identified in Code Sec. 469(c)(7)(B).
- Determine who is the real estate professional, husband or wife.
- Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Treas. Reg. § 1.469-5T(f)(4) to provide proof of services performed and the hours attributable to those services.
- Scrutinize other activities the taxpayer is engaged in to determine whether time claimed makes sense.
- Qualification as a real estate professional is a determination, not an election.
- During the initial interview, question the taxpayer regarding time spent in all activities (personal, business, civic, family, hobbies, etc).
- Request and closely examine the taxpayer’s documentation of time utilized for material participation in each activity.
- Examine time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc.
- Question the taxpayer in the initial interview whether an election was made, grouping rental real estate interests as a single activity.
- Request a copy of the return with the election. Request the original Form 1040, U.S. Individual Income Tax Return, from the IRS Center if doubts exist as to the documents furnished.
- Review prior and subsequent year’s returns for consistency.
- Closely scrutinize any passive income on Form 8582 line 1a. If the taxpayer is a real estate professional and did most of the work on the rental, gain on disposition does not belong on Form 8582.
- Tie down the taxpayer’s day-to-day involvement and specific hours regarding the activity.
- Request, as soon as possible, a log or other documentation itemizing the nature of the participation and the hours for each type of work claimed during the year.
- Request a copy of any management or commission agreement. Frequently, there is little left for the taxpayer to do.
 See Internal Revenue Code (Code) Sec. 162 and 212
 Code Sec. 469(c)(1)(A) and (B).
 Code Sec. 469(c)(2).
 Code Sec. 469(c)(7)(B)(i) and (ii).
 Code Sec. 469(c)(7)(B).
 Code Sec. 469(c)(7)(A).
 Code Sec. 469(c)(7)(B).
 Treas. Reg. Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).
 Moss v. Commissioner, 135 T.C. 365, 369 (2010) (citing Bailey v. Commissioner, T.C. Memo. 2001-296, and Goshorn v. Commissioner, T.C. Memo. 1993-578).
 See Tokarski v. Commissioner, 87 T.C. 74, 76-77 (1986); see also Chapman Glen Ltd. v. Commissioner, 140 T.C. __ (slip op. at 45 n.24) (May 28, 2013).
 See Moss v. Commissioner, 135 T.C. at 369.
 See Code Sec. 469(b).
 See Code Sec. 6662(b)(1) and (2).
 See Code Sec. 6662(c); Treas. Reg. Sec. 1.6662-3(b)(1)
 See Code Sec. 6662(d); Treas. Reg. Sec. 1.6662-4(b)
 Treas. Reg. Sec. 1.6664-4(b)(1); see also United States v. Boyle, 469 U.S. 241, 251 (1985) (reliance on an accountant or attorney as to a matter of tax law may be reasonable); Canal Corp. v. Commissioner, 135 T.C. 199, 218 (2010) (“The right to rely on professional tax advice, however, is not unlimited.”).
 Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); see also Charlotte’s Office Boutique, Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting with approval the above three-prong test), aff’g 121 T.C. 89 (2003). In addition, the advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. Treas. Reg. Sec. 1.6664-4(c)(1)(ii).
 See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99-100.