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

Taxpayers who engage in rental real estate activities will generally seek to have rental property losses from such activities characterized as non-passive. In several recent decisions, the Tax Court once again emphasized the importance of taxpayers being able to substantiate the time they claim to spend performing rental real estate services in order to qualify as a real estate professional and, thus, be able to claim rental losses as non-passive.

In two of the cases, the Tax Court denied deductions for real estate losses on the basis that the Taxpayer did not qualify as a “real estate professional” under Section 469(c)(7). However, in one of the cases, the Tax Court did find that an individual qualified as a real estate professional so that he could deduct the losses that were disallowed by the IRS.

Jones v. Comm’r.

In Jones,^[1] the Tax Court sustained the IRS’s disallowance of a couple’s deductions for rental property losses, finding that the husband did not qualify as a real estate professional under Section 469(c)(7) because he did not show that he spent more time performing services for the rental activity than for his insurance company.

The Taxpayer owned and operated an insurance company, Georgia First Insurance, LLC (“Georgia First”). According to the payroll records from Georgia First, the Taxpayer was paid for 519.99 hours of work during 2011 and 173.33 hours during 2012. Although the court noted that the payroll records showed the extent of the Taxpayer’s compensation from Georgia First, they did not necessarily show the total time that he spent performing services in connection with the business. During 2011 and 2012, the Taxpayer acted as Agency Manager employing three people, and was also responsible for taking photographs of any houses or properties subject to an insurance policy to be underwritten through Georgia First. In that regard, the Taxpayer drove to many locations within Georgia during the years in issue.

In addition to the personal services performed for Georgia First, the Taxpayer performed personal services with respect to ten rental real estate properties that he owned in 2011 and eleven rental real estate properties that he owned in 2012. Each rental property was a single-family home with three of the rental properties located in Texas, and the remaining properties located in Georgia. The Taxpayer was primarily responsible for managing and maintaining the rental properties and with respect to “Section 8 Housing Rental Properties,” the Taxpayer spent considerable time complying with requirements of that program, which included, among other things, annual inspections, tenant qualification, and the initial qualification of one real property purchased in 2012. The Taxpayer also met with prospective tenants, corresponded with tenants, negotiated and prepared leases, purchased supplies for repairs, met with contractors, personally made repairs, paid various bills, and collected rent due from tenants.

The Taxpayer maintained contemporaneous logs of the hours he claims to have devoted to the rental properties during 2011 and 2012. According to the logs, the Taxpayer spent 951 hours and 1,040 hours performing services for the rental properties for 2011 and 2012, respectively. The court noted that many of the hours reported in the logs related to travel time between Georgia and Texas. The court also noted that the logs provide generalized and abbreviated descriptions of the work that Taxpayer performed on a specific property on a specific day and the amount of time he spent on the activity described.

What is Passive Activity?

Section 469(a) generally disallows a deduction for a “passive activity loss” incurred by an individual. Section 469(c) defines a “passive activity” to include any activity involved in a trade or business in which the taxpayer does not “materially participate,” and any rental activity regardless of whether the taxpayer materially participates. Thus, rental activities are sometimes referred to as “per se” passive. However, Section 469(i) allows an individual who actively participates in a real estate activity to deduct against ordinary income up to $25,000 of losses from the activity, but only if the taxpayer’s adjusted gross income is less than $150,000 (the amount of the deduction phases out starting when the taxpayer’s adjusted gross income exceeds $100,000 and is completely phased out when adjusted gross income reaches $150,000).

Another exception to the rule that a rental activity is per se passive is the so called “real estate professional” exception. If a taxpayer qualifies as a real estate professional, then the rental activity is not deemed per se passive, and if the taxpayer can show that he materially participates in the rental activities, the losses from such rental activity will not be considered passive.

In order to qualify as a real estate professional the tax rules require taxpayers to, among other things, perform more than 750 hours of services during the tax year at issue in real property trades or businesses in which he or she materially participates, and also spend more time in real property trades or businesses in which he or she materially participates than in any other business.^[2] A real property trade or business means any real property development, re-development, construction, re-construction, acquisition, rental, operation, management, leasing or brokerage trade or business.^[3]

The regulations provide that hours of participation may be established by contemporaneous daily time reports, logs, or similar documents.^[4] Participation can also be established by other reasonable means, such as appointment books, calendars, or narrative summaries that identify the services performed and the approximate number of hours spent performing such services. However, for purposes of the regulation, the court is not required to accept post-event “ballpark guestimates,” nor is the court bound to accept the unverified testimony of taxpayers in the absence of adequate documentation.^[5]

The Tax Court in Jones found that other than the Taxpayer’s general testimony that he spent more time performing services for his real estate activities than he did for his insurance company, he did not present any evidence (such as time logs) or estimates of the total time he spent performing services for the insurance company from which the court could determine with any degree of certainty how many hours the Taxpayer dedicated to the insurance business during the years in issue. Because the Taxpayer failed to establish how many hours he spent performing services for the insurance business, the court concluded that the Taxpayer failed to establish that he spent more time on his rental real estate activities during the years in issue than he did for his insurance company, and accordingly, found that the Taxpayer did not qualify as a real estate professional.

About the Author:
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. 2017-6.

^[2] Section 469(c)(7)(B).

^[3] Section 469(c)(7)(C).

^[4] Reg. Section 1.469-5T(f)(4).

^[5] See, e.g., Lum v. Comm’r, TCM 2012-103; and Estate of Stangeland; TCM 2010-185.