When is a Taxpayer Not a Real Estate Professional?
Passive Activity Loss Limitation Rules Prevail! -or- The Story of the Barber Who Cut Too Much Hair!
The Tax Court recently ruled that although a taxpayer participated in rental activities within the $25,000 offset and elected to treat all of his properties as one activity, he did not qualify as a “real estate professional” and his real estate activities were “passive”.
The taxpayer in question worked as a barber, and his wife worked as a nurse. They owned five rental properties that the barber managed. The taxpayer claimed he was a real estate professional and deducted the losses incurred with respect to the rental properties owned with his wife.
There is a limited exception for rental real estate activities that permits taxpayers to use up to $25,000 of losses from rental real estate activities against nonpassive income. This exception applies only to rental real estate activities in which the taxpayer actively participates and only to the extent that the taxpayer would otherwise have a disallowed passive loss. (The $25,000 allowance phases out as taxable income increases).
The Tax Code defines a rental activity as “any activity where payments are principally for the use of tangible property.” Real estate is tangible property, thus rental activities involving real estate are passive activities unless an exception applies.
Rental activities are per se passive activities unless the activities conducted by taxpayers meet two requirements allowing them to be considered “real estate professionals.” A taxpayer is considered a real estate professional for a tax year if both the “more than half” test and the “more than 750 hour” test are met.
The first test requires that more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed 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 other brokerage trade or business.”
The second requirement is that the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. In order to be treated as materially participating in a trade or business activity, the taxpayer must be involved on a regular, continuous, and substantial basis.
To substantiate their claim that the barber was a real estate professional, the taxpayers submitted three documents. The first document was a sampling of the activities that he performed in the management of the rental properties.
The second document set out the hours spent on barber activities versus real estate activities for 2005 and 2006 and stated more hours spent on barber activities than on real estate activities in both years.
The third document purported to estimate the amount of time he spent on barber activities and real estate activities during the years at issue. The court concluded estimates in the third document inflated the hours spent on real estate activities, directly conflicting with the information in the other two documents. Consequently, the Tax Court concluded that because the taxpayer did not satisfy the first part of the definition of a real estate professional, he was not a real estate professional for 2005 or 2006, and therefore, the rental activities during those years were passive activities.
The court added that the taxpayer was liable for the related penalty because it found that he did not act with “reasonable cause and in good faith,” primarily based on the taxpayer’s failure to maintain contemporaneous books, logs, or records to substantiate the hours he purportedly spent managing the rental properties.
Contact Us: The moral of this story is don’t take chances with the tax code and compliance, consult a tax professional! Whether you are a barber or a nurse, or a lawyer, or a doctor, please contact Teri Kaye, CPA, Partner, with questions concerning the above issues or any other individual or corporate tax matters. Teri can be reached at 561-367-1040 or firstname.lastname@example.org.