Posted by: Lacey Strachan | April 16, 2020

Tax Court Finds a Personal Injury Attorney Was Not a Real Estate Professional By: LACEY STRACHAN

On April 13, 2020, the Tax Court issued an opinion in Hakkak v. Comm’r, T.C. Memo 2020-46, holding that a taxpayer was not a real estate professional in the tax years at issue for purposes of being able to qualify for the exception to the rule that rental activities are per se passive under the Section 469 passive loss limitation rules.[i]  The issue before the Tax Court was whether the taxpayer, a California attorney practicing primarily in personal injury, was a real estate professional within the meaning of Section 469(c)(7) as a result of his activities with respect to his investments in certain flow-through entities owning rental property.[ii]

The taxpayer at trial took a contrary position to his tax return.  On his tax return for the years at issue (2011 and 2012), the taxpayer reported his losses from his real estate rental activities as passive losses.  He then used these losses to offset shareholder income from his personal injury law practice, which he reported as passive income.  In the Notice of Deficiency issued following an audit, the IRS asserted that his income from his law practice was nonpassive (active) income, and as a result, could not be netted against the taxpayer’s passive losses from his rental activities.

At trial, the taxpayer contended not that the income from his law practice was passive, as stated on his return, but rather that his losses from two of his rental activities were in fact nonpassive, which would then allow the taxpayer to offset the losses against the nonpassive income from his law practice.  The rental properties at issue were two commercial rental properties located in Texas.  In addition to these two properties, the taxpayer had an interest in two additional commercial rental properties in Texas, two residential rental properties in California, and a gas station in California.

A taxpayer is a real estate professional under Section 469(c)(7) if, during the taxable year, the taxpayer spent more than 750 hours and half of his personal service hours in a real estate trade or business.  If a taxpayer qualifies as a real estate professional, the per se passive rule will not apply to the taxpayer’s rental properties and the taxpayer may demonstrate that he materially participated in the rental activities, making them nonpassive activities.[iii]

At trial, the taxpayer submitted the following evidence in support of his contention that he was a real estate professional during the years at issue: his testimony at trial, handwritten calendars (together with a partial transcription of these calendars), and documents consisting of emails and other written correspondence, lease agreements, bank account and credit card statements, invoices, loan statements and documents, photos, insurance documents, financial reports, property tax records, and various commercial real estate news articles.[iv]  He contended that he “exerted comprehensive and extensive time, effort, labor, and consideration relating to his operation, control and oversight” over the two properties in Texas.[v]  The Tax Court was unpersuaded, finding that the taxpayer’s “vague testimony discussing (at best) generalities about what he might have done and how long he might have spent does not sufficiently supplement or explain the calendar entries.”  The Tax Court further found that the evidence showed that much of his time was spent on investor-type activities, which don’t count for purposes of the 750-hour requirement.[vi]  In fact, day-to-day management of the rental properties was handled by a property management company and a leasing agent was used to find new tenants.

Moreover, the Tax Court found no evidence that the taxpayer spent over half of his personal service hours on real estate trade or business activities during the taxable year, other than the taxpayer’s self-serving testimony it found to be unreliable.[vii]  This is a particularly difficult obstacle to overcome for taxpayers who have a full time job in a non-real estate trade or business.  It is important for taxpayers seeking to take advantage of the real estate professional exception to document the time the taxpayer spent on all personal services during the relevant tax years, both real estate-related activities and non-real estate activities, such as the practice of law.

Because the Tax Court held that the taxpayer was not a real estate professional, the court did not have to decide the question of whether the taxpayer materially participated in the rental activities at issue.

Lacey Strachan is a Principal at Hochman Salkin 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).  Ms. Strachan has experience in a wide range of civil and criminal tax cases, including cases involving technical valuation issues, issues of first impression, and sensitive examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise. 

[i] Hakkak v. Comm’r, T.C. Memo 2020-46.  The Petitioners were a husband and wife who filed a joint return.  In this blog post, the “taxpayer” refers to the husband.

[ii] For a background discussion on the Section 469 passive loss limitation rules as they pertain to rental real estate, see Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 1: General Overview,” Taxlitigator – Tax Controversy (Civil & Criminal) Report, August 29, 2017, https://taxlitigator.me/2017/08/29/a-primer-on-material-participation-rules-for-real-estate-businesses-part-1-general-overview-by-lacey-strachan/.

[iii] For additional discussion about the real estate professional exception to the passive loss rules, see Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 2: Who is a Real Estate Professional?” Taxlitigator – Tax Controversy (Civil & Criminal) Report, September 12, 2017, https://taxlitigator.me/2017/09/12/a-primer-on-material-participation-rules-for-real-estate-businesses-part-2-who-is-a-real-estate-professional-by-lacey-strachan/ and Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 4: Special Considerations for Real Estate professionals with Rental Activities,” Taxlitigator – Tax Controversy (Civil & Criminal) Report, October 14, 2017, https://taxlitigator.me/2017/10/14/a-primer-on-material-particiation-rules-for-real-estate-businesses-part-4-special-considerations-for-real-estate-professionals-with-rental-activities-by-lacey-strachan/.

[iv] Hakkak at *16-*17.

[v] Id. at *17.

[vi] Id.

[vii] Id. at *18-*19.


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