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Part II: Passive Activity Loss Limitation and Real Estate Professional Tax Rules

Published: June 7th, 2017

By: Stephen R. Looney

In Part I, we discussed the passive activity and loss limitation rules and how they can affect real estate losses. In Jones vs. Comm’r, the taxpayer failed to provide logs from their insurance job, which resulted in a non-qualification as a real estate professional. This week, we look at the Makhlouf v. Comm’r case, which provides another example of the passive activity loss limitation rules. In this case, the taxpayers did provide logs, but they were found to have inflated hours, which led to another non-qualification as a real estate professional.

Makhlouf v. Comm’r

In Makhlouf, [1] the Tax Court sustained the IRS’s disallowance of a couple’s rental real estate loss deductions as passive because neither of them were real estate professionals, finding that they inflated the number of hours spent on the rental of their former residence and on rental properties the husband owned with his family in Egypt.

The Taxpayers, Mr. and Mrs. Makhlouf, owned a rental property in Massachusetts (their former residence) and during the year in issue, Mr. Makhlouf was one of the eighteen owners of two apartment buildings in Cairo, Egypt (the “Dokki Property”). The other seventeen owners of the Dokki Property were members of Mr. Makhlouf’s family. During 2010, Mr. and Mrs. Makhlouf visited Egypt twice, from January 1 to February 21 and from December 9 to December 31. During both visits, they stayed in an apartment at the Dokki Property. Mr. Makhlouf testified that he held a 20% interest in the Dokki Property and received a ratable portion of the rent from it during 2010.

Although Mr. and Mrs. Makhlouf were retired during 2010, they alleged they engaged in extensive management activities with respect to both their Massachusetts property and the Dokki Property. The Taxpayers prepared spreadsheets for each property and reported 792 hours attributable to Mr. Makhlouf’s activities with respect to the Massachusetts property and 806 hours attributable to Mrs. Makhlouf’s activities with respect to the Massachusetts property. This time included 129 hours traveling between their residence and the rental property, which are roughly 120 miles apart, 64 hours paying bills and 685 hours performing other tasks. On another spreadsheet provided by the Taxpayers for the Dokki Property, the Taxpayers reported 353 hours attributable to Mr. Makhlouf’s activities and 253 hours attributable to Mrs. Makhlouf’s activities. This time included 88 hours traveling from Massachusetts to Cairo and 518 hours performing tasks (mostly attending family meetings). A diary of their trips to Egypt showed substantial amounts of time devoted to personal activities, including touring the pyramids and visiting Luxor.

In short, the court found that both the spreadsheet for the Massachusetts property and for the Dokki Property were not maintained contemporaneously, were implausible on their face, and included inflated hours. As such, the Court concluded that neither Mr. Makhlouf nor Mrs. Makhlouf qualified as a real estate professional during 2010, and accordingly, sustained the IRS’s disallowance of their rental real estate loss deductions.

Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at slooney@deanmead.com.

[1] T.C. Summ. Op. 2017-1.