In a recent Tax Court case, the court concluded that a taxpayer, who also engaged in a consulting activity, wasn’t a real estate professional for purposes of the passive activity loss (PAL) rules. He failed to show that more than half of the personal services that he performed during the year were performed in real property trades or businesses in which he materially participated.
Under Code Sec. 469(c)(1), the PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. In general, any rental activity is per se a passive activity regardless of the taxpayer’s participation in the activity. However, there are an exceptions to the per se rule for: (a) real estate professionals; and (b) up to $25,000 of losses, subject to an adjusted gross income (AGI) phaseout.
Under Code Sec. 469(c)(7), the per se rule for rental activities doesn’t apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if:
(1) more than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and
(2) he performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates. For taxpayers filing a joint return, either spouse may separately satisfy the real estate professional requirements.
If a taxpayer is a qualifying real estate professional, the PAL rules generally are applied as if each interest of the taxpayer in real estate were a separate activity. But, under Code Sec. 469(c)(7), the taxpayer may elect to treat all his interests in rental real estate as one activity.
What did the taxpayer do wrong?
1. Kept no separate bank account for these rental activities and used his personal account to pay expenses.
2. Kept no contemporaneous log or other documentation to record the number of hours he spent working on his rental properties.
3. There was no election to treat all of his rental properties as a group.
4. Did not complete line 43 on any of his Schedules E to indicate that he considered himself to be a real estate professional
5. Failed to demonstrate that he spends more than half of his personal services during the year in real property trade/business (he was also an engineering consultant)
6. Testimony regarding the time he spent on his consulting activities and his rental real estate activities was vague and indefinite
7. Merely being on call to perform services wasn’t sufficient to include in the hour totals
This case illustrates how difficult it is for a taxpayer to qualify as a real estate professional for purposes of the PAL rules and the necessity of taking steps to document the extent of one’s required participation in that activity. Please let us know if we can help in this area.
By Jeremy Smith, CPA