In Brown v. Commissioner, T.C. Summary Op. 2015-62 (October 15, 2015), the Tax Court held that the taxpayers’ losses from rental activities were non-passive. The case illustrates how the Tax Court will review the real estate professional test as well as the separate material participation tests to determine if rental activities are non-passive.
The taxpayer in Brown operated a real estate construction business as a sole proprietor. The taxpayer, his wife, and their family, lived in the first floor of a multifamily house, and rented out the remaining floors. The passive loss issue relates to rental losses incurred with respect to the upper floors and common areas. The taxpayer maintained a contemporaneous log of time spent on cleaning and extensive repairs that he performed with respect to the property, although this log included both the time spent on the rental floors, as well as common areas and the floor that the taxpayer used personally.
Real Estate Professional – Rental activity is generally treated as a per se passive activity.[i] Such losses are restricted in how and when they may be utilized to offset non-passive income.[ii] Under the real estate professional exception, rental activity is not treated as per se passive provided that the taxpayer satisfies the following two requirements:
- 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
- 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[iii]
Material Participation – A taxpayer is treated as materially participating in an activity if the taxpayer participates for more than 500 hours per year on the rental activity.[iv] Real property trade or businesses is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” [v] Here, the Court applied this definition to the taxpayer’s activities and concluded that both his real estate construction activities (i.e. from his sole proprietorship) and his maintenance and repair activities (i.e. on the rental property) were material participation activities because they each exceeded 500 hours. Together, the husband’s activities exceeded the 750 hours test for a real estate professional, and these activities constituted more than half of his time. As such, he established that he was a real estate professional. Ultimately, the Tax Court also held that the taxpayers materially participated in the rental activity[vi].
Contemporaneous Log – The case illustrates how a taxpayer’s historical documents used for tracking a real estate activity may be less than perfect when scrutinized in preparation for trial. Here, the contemporaneous log included information hours that did not “count” because they were hours related to parts of the property that were not rented, such as common areas they used personally, or their own residence. In anticipation of trial, the Petitioners prepared and submitted additional documentation that carved out such hours, to help meet their burden of proof to show that they still had sufficient hours to meet the material participation tests. The record also contains references to specific repairs that the taxpayer performed on the upper floors on which the taxpayers did not reside. Credible testimony regarding actual work performed (i.e. from a bike hitting the rental floor hallway), combined with schedules, can help a trier of fact weigh the evidence in a case. Despite efforts by the government to establish inconsistencies in between the contemporaneous logs and the materials prepared for trial, the taxpayers met their burden in establishing their material participation.
Although a summary opinion, and not citable as precedent in other cases, the case provides a helpful analysis of how the real estate professional rules work in conjunction with the material participation rules in the regulations. It is also a practical reminder that even taxpayers who maintain contemporaneous logs may face challenges in establishing that their rental activities were non-passive. When the scope of time spent on a rental activity may be unclear, such as here where a taxpayer lived in a building she also owned and rented, it may be helpful to keep additional records to differentiate and prove the specific activities each year.
CORY STIGILE – For more information please contact Cory Stigile – firstname.lastname@example.org Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state civil and criminal tax controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at www.taxlitigator.com
[i] IRC § 469 (c)(2).
[ii] IRC § 469 (a).
[iii] IRC §469(c)(7)(A)(i).
[iv] IRC § 1.469-5T(a)(1).
[v] IRC § 469(c)(7)(C). See sec. 1.469-5T(a)(1)
[vi] The real estate professional authorities also may trigger favorable consequences with respect to “grouping” of real estate rental activities for purposes of applying the material participation rules, but as noted above, the taxpayer only rented one property.