Issue
Who qualifies as a real estate professional for tax purposes? More specifically, how does a taxpayer establish that he or she materially participate in rental activities, so that the rentals become non-passive, and any losses can be used without limitation?
Related Tax Rules and/or Regulations
Internal Revenue Code Section 469
Facts
Escalante earned income from teaching and his ownership of rental properties that he managed himself. His teaching contract required him to work a minimum of six hours per scheduled work day. As is customary with this type of contract, it contemplated that there would be a substantial number of hours spent outside the classroom engaging in tasks and activities like lesson planning, grading papers, parent-teacher consultations, and faculty meetings.
In 2005, 2006, and 2007, Escalante claimed on his tax returns that he was a real estate professional, and that therefore his rental losses were permitted in full. The IRS immediately denied the losses after it took note from Escalante’s tax return that he was gainfully employed in a non-real estate field, yet claimed real estate professional status.
Decision
Under IRC §469, as a general rule, all rental activities are considered “passive” regardless of the extent to which the taxpayer participates in the rental. As a result, losses from a rental activity are generally only permitted to reduce income from a passive activity (although there is a limited $25,000 loss available to certain taxpayers who “actively participate” in their rentals under Section 469(i).)
There is a large exception to this default treatment of rental activities as passive, however, for individuals that can legally demonstrate they are “real estate professionals.” If a taxpayer qualifies as a real estate professional and can also establish that he or she materially participates in the rental activities, the rentals become non-passive, and any losses can be used to offset other income without limitation. Section 469(c)(7) requires more than half of the taxpayer’s personal services for the year to be spent in real property trades or businesses in which the taxpayer materially participates.
In Tax Court, Escalante consequently had the burden of establishing that he spent more than half his time during the relevant tax years on his rental properties. Escalante responded with a log that showed he worked four times as many hours managing his rentals than teaching in 2005 (teaching: 618 managing: 2,540)! Almost six times as many hours in 2006 (teaching: 390 managing: 1,989)! His log for 2007 was not as drastically weighted in favor of managing rentals as it showed a 2:3 teaching/managing ratio of hours. Still, this showed 60% of his time was spent on real estate-related work.
The first problem with Escalante’s logs was that used the minimum possible hours to quantify his teaching work. Simply, six hours multiplied by the number of days in service. The logs contained no evidence of anything like class preparation or any “off-site” activities. The court explained, “…his failure to record this time in the logs undermines their reliability.” Also, to worsen matters for Escalante, he greatly exaggerated the time spent on simple, routine functions, like check-writing, as his entries indicated that each check took a minimum of one hour to prepare. In further examining Escalante’s logs, the court found that he had worked more than 24 hours on some days.
The court summarized Escalante’s records thusly, “Simply put, the logs are insufficient to show that petitioner has satisfied the tests set forth in Section 469(c)(7)(B), and his testimony in that regard was, understandably, too generalized to otherwise do so.” As a result, Escalante, like so many before him, failed to qualify as a real estate professional, for tax purposes.
What It Means
Taxpayers that have a full time job in a non-real estate field and “dabble” on some level in the real estate market have a heavy burden to bear in meeting the “more than half” test. The IRS and courts are always skeptical of these situations and taxpayers must carefully document all real estate-related activities to overcome the “more than half” test. They certainly must keep better records than Richard Escalante, and be more credible. Thus, although IRS rules and regulations do not require contemporaneous entries, records or logs to be kept to establish personal real estate services, accurate, consistent, and, most importantly, realistic record-keeping measures are absolutely necessary to ensure that rentals become non-passive, and any losses can be used without limitation.
If you derive income from work as a real estate professional as well as a second, unrelated occupation, and have questions about income deductions, or generally have questions about deductibility of your losses, call THE TAX EXPERTS AT THE Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
