Posts Tagged ‘material participation’

Tax Roundup, 3/17/16: Brokering mortgages isn’t “real estate activity,” says Tax Court. And: Irish scenery!

Thursday, March 17th, 2016 by Joe Kristan

All photos today courtesy Dan Kristan

Sometimes training isn’t enough. A taxpayer whose case was decided this week in Tax Court seems well equipped to fight the IRS:

Petitioner holds a bachelor of science degree in accounting and a master’s degree in tax law. During each year in issue petitioner was licensed in California as a real estate broker and was qualified to represent taxpayers before the Internal Revenue Service (IRS) as an enrolled agent.

A specialized tax degree and an E.A. designation is pretty strong background, but credentials don’t always get the job done.

The taxpayer’s business involved mortgage brokerage, real estate brokerage, and tax preparation. The taxpayer argued that the time he spent as a mortgage broker counts as a “real estate trade or business,” enabling him to treat rental losses as non-passive and therefore deductible.

Some background. The tax law treats rental losses for most taxpayers as automatically passive, and therefore deductible only to the extent of “passive” income or at the time the “passive activity” is sold.

Business activities other than real estate rental are not automatically passive. Taxpayers can avoid the passive loss rules if they “materially participate” in the activity. This is based on the amount of time spent on the activity.

If you qualify as a “real estate professional,” your real estate losses are not automatically passive; they are tested as passive or non-passive based on the tests used for other businesses. But it is hard to be a real estate pro under these rules:

-You have to spend at least 750 hours a year working in a “real estate” trade or business, and

-Your real estate time has to exceed the time you spend doing non-real estate work.

This second test keeps most people from being real estate pros, as its hard to convince the IRS or the courts that you have a 2000-hour full time job but that you spend more time than that managing real estate.

The taxpayer in this case said his mortgage brokerage was a real estate business:

According to petitioners, petitioner’s mortgage brokerage activity is a “real property trade or business” within the meaning of section 469(c)(7)(C). Petitioners go on to argue that because petitioner spent more than 750 hours providing services in connection with his mortgage brokerage business for both years in issue, and because he spent more time in that business than he did in any other trades for business during each of those years, for both years in issue he is a [real estate professional]…

This is the first time I’ve seen mortgage brokering treated as a “real estate” trade or business. The Tax Court ponders the question (my emphasis):

Section 469(c)(7)(C) defines a real property trade or business to mean “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” Petitioners focus on the word “brokerage” contained in that section and argue that petitioner’s mortgage brokerage business is contemplated by the statute. We disagree. Petitioners’ argument ignores the words “real property” that precede the specific activities listed in the statute; those words modify each of those activities. While petitioner’s mortgage brokerage activity constitutes a “brokerage” trade or business, it does not constitute a “real property brokerage” trade or business. Petitioner was not during either year in issue brokering real estate; he was brokering financial services.

The court was unconvinced that the taxpayer met the 750-hour test without counting the mortgage brokerage time, so the rental losses were passive and disallowed. The issue was novel enough, though, for the taxpayer to avoid penalties.

The Moral? Credentials are helpful to a tax preparer, but they aren’t always enough to convince the Tax Court to see things your way.

Cite: Guarino, T.C. Summ. Op. 2016-12.




Scott Drenkard, Sights and Sounds from Kansas as they Consider Bill to Eliminate Pass-through Carve-out:

Kansas is on the right track by broadening its tax base and lowering its rates, but should be cautious about favoring some businesses over others. A better path to encouraging economic growth is creating a tax environment that is not overly burdensome and treats all businesses well. Further, while tax reductions can have positive economic benefits, they will cost revenue and will ultimately have to be paid for either by cutting spending or increasing taxes elsewhere.

If Iowa ever gets around to much-needed business tax reforms, Kansas will provide a good bad example.


TaxGrrrl, 7 Options To Consider When You Can’t Pay Your Tax Bill In Full. With this importand advice: “What if you know that you can’t pay what you owe? File anyway.

Robert Wood, Before Filing Your Taxes With IRS, Consider This. “As you start preparing to file your tax return this year, consider what will happen if you are audited.”

Keith Fogg, A Different Type of Offset Fight – Illegal Exaction (Procedurally Taxing). “In the end, this type of case appears extremely difficult to win which is why so few of these cases make it to published opinions.”

Paul Neiffer, IRS Interest Rates Finally Start to Rise. “It seems like forever that the interest that the IRS will pay or collect on tax refunds/underpayments has been stuck at 3%.  The IRS just announced today that beginning April 1, 2016, the interest rate will rise to 4% for most taxpayers.”

Kay Bell, New tax scam alert: Cons posing as fake IRS agents now calling to ‘verify’ filers’ tax return information




TaxProf, The IRS Scandal, Day 1043

Renu Zaretsky, Caution, Cuts, and a Chunk of Change. Today’s TaxVox headline roundup covers budget battles in Minnesota and proposed corporate tax cuts in the U.K., among other things.


Career Corner. Study: Women Even Less Willing to Put Up With Crappy Pay Than Men (Caleb Newquist, Going Concern)


Tax Roundup, 10/19/15: Keeping a calendar pays off big for Brooklyn apartment owner. And: Irwin Schiff dies in prison.

Monday, October 19th, 2015 by Joe Kristan

20150811-1Marking time pays. If you ever think owning income property is easy money, a Tax Court case last week might make you think twice. But the case also shows how keeping track of the time you spend can make a big difference if the IRS questions your rental losses.

The taxpayer couple owned “a four-floor mulifamily house” in Brooklyn. The couple lived on the first two floors, and rented out the two remaining floors as two apartments. He had a day job involving construction, but he also had his hands full with the apartment.

The couple claimed just under $70,000 of rental losses between 2010 and 2011. The IRS challenged the losses. The IRS has a good track record in rental loss cases because the tax law sets a high bar for deducting them. Such losses are automatically “passive,” and deductible only to the extent of “passive income,” unless you are a “real estate professional.” To be a real estate professional, you have to

  1. work more than 750 hours in a real estate trade or business during the year, and
  2. Your real estate work has to take more time than anything else you do.

It’s that second test that usually trips up people with day jobs. The taxpayer here, though, had an advantage, as Special Trial Judge Panuthos explains:

For purposes of the requirement in section 469(c)(7)(B)(i) [the real estate professional test], a real property trade or business includes construction and reconstruction. Sec. 469(c)(7)(C). 

So that meant the rental activity didn’t have to take more time than the day job. But the real estate professional rule doesn’t automatically make a rental loss deductible. The taxpayer still had to show that he “materially participated” to avoid the passive loss rule. Material participation is generally based on time spent working on the activity during the year, with 500 hours annually being the most common threshold used.  Fortunately, the taxpayer kept track of his time:

We used petitioner’s contemporaneous activity log to calculate the amount of time that he spent on the rental property. We included the amount of time petitioner recorded in his contemporaneous activity log for the work related to the tenants’ apartments and two-thirds of the amount of time petitioner recorded in his contemporaneous activity log for the work related to the common areas. On the basis of these calculations, we conclude that petitioner spent 1,008 hours performing services with respect to the rental activity for 2010. Because the 1,008 hours meets the more-than-500-hour requirement of section 1.469-5T(a)(1), Temporary Income Tax Regs., supra, petitioner meets this requirement for the 2010 taxable year. Accordingly, petitioner materially participated in the rental real estate activity for 2010, and petitioner’s 2010 rental real estate activity was not a passive activity.

That’s a lot of time. So much for the idea that rental income is easy money. The taxpayer’s records also carried the day for 2011. In total, the recordkeeping saved the taxpayer $25,174.60 in taxes and penalties that the Tax Court overturned.

The Moral? Keeping a daily calendar of your time is the best antidote to an IRS passive loss examination. It may seem like a hassle, but as this case shows, it can turn out to be the best investment of time you can make if the IRS comes for a visit.

Cite: Simmons-Brown, T.C. Summ. Op. 2015-62.


Irwin SchiffTax Protester Schiff dies in prisonIrwin Schiff, a prominent figure among those denying the general application of the income tax, died in prison last week, reports Peter Reilly. Mr. Schiff, 87, had been diagnosed with lung cancer while serving a 13-year sentence for practicing what he unwisely preached. Peter’s humane and thoughtful coverage includes this:

When I first encountered Schiff’s arguments in the nineties I was so impressed by how well put together they were, that I found it difficult to believe that they were constructed by someone who believed them, as citations always checked out, but were wildly out of context.  Irwin, however, has proved his sincerity.  That doesn’t make his arguments right, but it does merit some grudging admiration.

Mr. Schiff’s story shows that however sincerely you believe that the income tax doesn’t apply to you, your sincerity does little good when the IRS, the U.S. Marshals, the federal judges, and the Bureau of Prisons think it does. And they do.



Russ Fox, That Was the Year that Was. Russ reflects on the filing season ended last week:

Calling the IRS was almost a joke. The “Practitioner Priority Service” hold times were so bad that I’d hate to think of what they were for regular numbers. Unfortunately, I see no improvement possible with the IRS budget until the IRS scandal is resolved. That’s not going to happen until we have a new President, so we have probably two more years of misery in dealing with the IRS.

At least.


William Perez, Where to Find and How to Read Tax Tables

Annette Nellen, Responsible Governance – Tax break bills vetoed! “What happened – On 10/10/15, Governor Brown vetoed nine bills that either created or expanded a tax credit or exclusion or exemption.”




Alan Cole, How Do Property Taxes Vary Across The Country? (Tax Policy Blog). The post feature a handy interactive map showing the average property tax deduction taken in each U.S. county in 2013.

TaxProf, The IRS Scandal, Day 891Day 892ay 893. Day 892 covers the connection between Lois Lerner and a bureaucrat behind the outrageous Wisconsin “John Doe” investigations of conservative organizations.

Howard Gleckman, The Debt Limit: Here We Go Again (TaxVox).

Kay Bell, GOP presidential candidates tax trash talk on Twitter

Robert Wood, Execs Get 10 Years Prison Over Company Taxes? Yes, Here’s How. Robert covers the Arrow Trucking saga.

TaxGrrrl, As TIGTA Continues To Warn On IRS Scams, New Treasury Scams Surface. “In one version, scammers advise that an individual has been awarded a grant or a similar sum of money and in order to collect, the individual needs to provide personal information or a sum of money to ‘release’ the funds. It sounds a little bit like those lottery scams making the rounds but the use of the name of the Office of the Treasury seems to make individuals believe that it’s more legitimate”


News from the Profession. A Noncomprehensive List of Morale Boosters for Accounting Firms (Leona May, Going Concern). “Accounting firms, who generally eat their young, are all competing for ‘who has the best perks’ in race to scoop up all of the competent new hires.”



Iowa Capital Gain Break: how it works when you rent property to your business

Friday, October 5th, 2012 by Joe Kristan


Flickr image by John Snape used under Creative Commons license

The Iowa Department of Revenue has released a Policy Letter illustrating how Iowa’s “10 and 10” capital gain exclusion works when you own business real estate in one entity and the operating business in another.  The rule allows taxpayers to exclude capital gain from Iowa income on the sale of business real estate* held for ten years and used in a business in which the also has taxpayer “materially participated” in for ten years.The facts from the policy letter (my emphasis):

Both scenarios involve a taxpayer who is a nonresident of Iowa.  This taxpayer owns an interest in his business, an S corporation, for more than ten years.  The taxpayer has been a material participant in the S corporation for more than ten years.  The S corporation does business solely within Iowa.

Under the first scenario, the S corporation sells real estate in a sale/leaseback transaction.  The real estate has been owned by the S corporation for more than ten years.

In the second scenario, the taxpayer owns a controlling interest in a limited partnership.  The partnership has rented Iowa real estate to the S corporation for more than ten years.

You are asking if the capital gain from the sale of the real estate in both scenarios would qualify for the Iowa capital gains exclusion.

Iowa follows the federal “passive loss” Section 469 rules in defining “material participation.”  The letter says that the gain in both cases qualify for the exclusion — even though the taxpayer is an Iowa non-resident, and even though in the second scenario the real estate isn’t owned in the same entity in which the material participation occurs:

Similarly, in regard to the second scenario, as long as the taxpayer materially participated in the operations of the partnership by meeting one of the section 469(h) tests for the ten years prior to the date of the sale, the taxpayer is eligible to claim the Iowa capital gain deduction for this0`1w   sale.  The fact that the federal passive loss rules deem net income from self-rental as non-passive income does add additional support for this conclusion. 

The letter comes to the correct conclusion.  Non-residents can qualify for the Iowa capital gain exclusion, and real estate used in the business can qualify even when the real estate is owned in a separate entity by the participant.

*It also allows taxpayers to exclude gains on the sale of an entire business when the 10-and-10 standards are met.  More here.


“Self-Rental rule” trips up trucking company

Thursday, August 9th, 2012 by Joe Kristan perennial tax problem for owners of “C corporations” is getting cash out of the corporation without it being taxed twice.  Unlike “S corporation” income, C corporation income is taxed twice: first under the corporate income tax rules when it is earned, and again as taxable dividend income when distributed to the shareholders.

A common tactic to extract C corporation income without a second tax is to rent property to the corporation.   While the owner has to report the rental payments as income, the corporation gets a rental expense deduction, netting to only one tax.  But this plan has its own risks, as a C corporation owner learned yesterday in Tax Court.  The Tax Court held that the “self-rental” rule kept the taxpayer from deducting rental losses from leases of equipment to his corporation.

Tax Court Judge Wells sets the stage (my emphasis):

Mr. Veriha is the sole owner of John Veriha Trucking, Inc. (JVT), a corporation with its principal place of business in Wisconsin. JVT was a C corporation during 2005 but has since elected S corporation status. Petitioners were both employed by JVT during 2005, and Mr. Veriha materially participated in JVT’s business. JVT is a trucking company that leases its trucking equipment from two different entities, Transportation Resources, Inc. (TRI), and JRV Leasing, LLC (JRV). The trucking equipment JVT leases consists of two parts: a motorized vehicle (tractor) and a towed storage trailer (trailer).

     TRI is an S corporation in which Mr. Veriha owns 99% of the stock; his father owns the remaining 1%. TRI is an equipment leasing company with its principal place of business in Wisconsin. TRI owns only the tractors and trailers that it leases to JVT. During 2005, TRI and JVT entered into 125 separate lease agreements, one for each tractor or trailer leased. TRI’s only source of income during 2005 was the leasing agreements with JVT.

     JRV is a single-member limited liability company, and Mr. Veriha is its sole member. JRV is an equipment leasing company that owns only the tractors and trailers that it leases to JVT. During 2005, JRV and JVT entered into 66 separate lease agreements, one for each tractor or trailer leased. JRV’s only source of income during 2005 was the leasing agreements with JVT.

In 2005 TRI had income from its rental, but JRV, the single member LLC, reported a loss.  Rental income and loss is normally “passive,” and passive losses are only deductible to the extent of passive income.

When the passive loss rules were enacted, the IRS feared that business owners would set up deals with their businesses to generate passive income, enabling them to deduct otherwise deferred passive losses.  To combat this, the IRS issued regulations holding that net income from renting to your own business would not be passive if the income from the business isn’t itself passive.  The IRS used these regulations to keep Mr. Veriha from deducting his rental losses against his rental income.  The taxpayer argued the losses of JVT should be lumped together with the income from TRI, with only the net income of the two treated as non-passive.

The Tax Court sided with the IRS:

Section 1.469-2(f)(6), Income Tax Regs., explicitly recharacterizes as nonpassive net rental activity income from an “item of property” rather than net income from the entire rental “activity”. Section 469 and the regulations thereunder distinguish between net income from an “item of property” and net income from the entire “activity”, which might include rental income from multiple items of property.

we conclude that each individual tractor and each trailer was a separate “item of property” within the meaning of section 1.469-2(f)(6), Income Tax Regs. However, because respondent has not contested petitioners’ netting of gains and losses within TRI, only TRI’s net income is recharacterized as nonpassive income.2

That last sentence has to be scary to anybody renting multiple properties, like a trucking fleet, to a controlled business.  The Tax Court is saying that the IRS could have required the taxpayer to determine the income from each truck and tractor leased to the business, with all income leases non-passive and all losses passive.  The Tax Court in its footnote spells it out:

We note that this result is necessarily more favorable to petitioners than the result would have been had respondent contended that it was necessary for the income from each tractor or trailer within TRI and JRV to be recharacterized as nonpassive.

That implies that the IRS was just being “nice” this time, and another taxpayer with similar facts could do much worse.

The moral: Taxpayers who rent to their own businesses — at least those in which they “materially participate” —  need to remember that they can’t offset passive losses with that rental income.  If they rent many items to their business, they need to make sure that every lease generates a profit, or the IRS might split them out and disallow all the losses.

Cite: Veriha, 139 T.C. No. 3.

More on the passive loss rules here.


Department of Revenue asks legislature to trim back real estate gain exclusion

Thursday, March 29th, 2012 by Joe Kristan

While the annual Iowa Department of Revenue policy bill is usually a snoozer, dealing with minor technical problems in the tax law, this year it’s more ambitious.  When a Senate Ways and Means subcommittee meets to discuss SSB 3117 this morning, one of the items on the Department’s agenda is to trim back the deduction for sales of business real estate.  Iowa currently allows many taxpayers who have held rental real estate for at least ten years to exclude gains from the sale of the real estate from income if they also meet a ten-year “active participation” requirement. 

The Department’s new bill makes the requirements much stiffer. From the bill’s explanation:

   The division amends Code section 422.7, relating to the Iowa capital gain exclusion, to provide that capital gains from the sale of real property used in a business or from the sale of a business which is defined as a passive activity business under section 469(c) of the Internal Revenue Code does not qualify for the exclusion. This provision of the bill applies retroactively to January 1, 2012, for tax years beginning on or after that date.

I asked the Department for a clarification and received this explanation from the Department’s policy chief, Jim McNulty (my emphasis):

The intent of the proposal is to not allow rental activities to qualify for the capital gain exclusion unless they are a real estate professional, which is the 750 hour/50% test that you cited.

 The Department has taken a position, which has been upheld by an Administrative Law Judge decision, that cash rent of farmland does not qualify for the Iowa capital gain exclusion.  We have received concerns that while rental of farmland does not qualify in many cases, rental of commercial property often does qualify.  The intent of this change is to better equalize the treatment regarding rental activities, whether they relate to farmland or commercial property.  This would still allow real estate professionals to claim the exclusion.

The bill would allow the exclusion for rental real estate only for taxpayer that meet the “rental real estate professional” hurdle of Section 469(c)(7).  To qualify, a taxpayer has to work more than 750 hours in real estate trades or businesses and spend more time in that than in any other activity.  Then the taxpayer also has to prove “material participation” in the rental real estate activity.    The current rules for the exclusion are much more lenient:

7. Rental activities or businesses.

 For purposes of subrules 40.38(1) and 40.38(7), the general rule is that a taxpayer who actively participates in a rental activity or business which would be considered to have been material participation in another business or activity would be deemed to have had material participation in the rental activity unless covered by a specific exception in this subrule (for example, the exceptions for farm rental activities in numbered paragraphs “4,” “5,” and “6” immediately above). Rental activity or rental business is as the term is used in Section 469(c) of the Internal Revenue Code.

This means, for example, that a taxpayer who is not a “real estate professional” who spends 100 or more hours on a real estate rental activity, and more time than anyone else, could qualify now but would not qualify under the law proposed by the Department.  The new rules would take effect retroactively to the beginning of this year. 

I’m not a big fan of the Iowa long-term gain exclusion; I think much lower rates without complex exclusions would be a better way to go.  Still, trimming back this exclusion shouldn’t be the job of the Department’s policy bill, especially on a retroactive basis.  It should be part of a larger discussion of how Iowa’s tax law works.


Iowa Capital Gain Deduction: an illustration

It’s hard to be a real estate professional 



Did the Tax Court just abandon the ‘750 hours for every rental activity’ test?

Monday, September 12th, 2011 by Joe Kristan

Last year a Tax Court decision implied an additional hurdle for taxpayers wanting to claim that they “materially participate” in an activity. A decision last week appears to have quietly removed this hurdle.
Net rental losses are normally “passive” unless you qualify as a “real estate professional.” Passive losses are deductible only to the extent of passive income. If you qualify as a real estate pro, then you can deduct rental losses if you “materially participate” in your real estate activities under the same participation tests that apply to other activities.
To be a real estate pro, you have to pass two tests:
– You have to participate more than 750 hours in a real estate trade or business, and
– Your real estate activities have to take more time than anything else you do.
A 2010 Tax Court decision said there was an additional test:

Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.

At the time I argued that the last sentence was wrong — that the 750 hour test does not apply separately to each rental activity absent the “aggregation election.” A decision last week may indicate that the court has seen the light on this issue.
Last week’s case (discussed here) involved a taxpayer who had a day job that wasn’t in real estate, but that left him enough free time to do a lot of real estate work on his own properties. The Tax Court found that he was a qualifying real estate pro:

On the basis of the record and testimony provided at trial, we find that Mr. Miller has established that he spent more than 750 hours performing significant construction work as a contractor and on his rental real estate activities. We find that Mr. Miller spent more time on his construction work and rental properties than he did piloting vessels in the years at issue.

Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B)

The judge noted that Mr. Miller had not elected to “aggregate” his properties. Nowhere in the analysis of whether the taxpayer qualified does the judge consider whether he had to work 750 hours in each property to be able to count the rental hours towards the 750-hour minimum; in fact, he found that none of the properties reached the 750 hour requirements on their own.
I think that means the Tax Court has come around to my view. Sure, it would be nice if they would cite the Tax Update Blog in their decision (ahem!), but as long as they get the law right, that’s what matters.
Cite: Miller, T.C. Memo. 2011-219


Real estate tax tip: have a cushy day job

Friday, September 9th, 2011 by Joe Kristan

If you have a day job that’s not in the real estate business, it’s hard to qualify for the “real estate professional” loophole in the “passive loss” rules. The tax law treats losses from rental real estate activity as automatically “passive” if you don’t qualify, and those losses are only deductible if you have “passive” income. If you are a real estate pro, you can deduct real estate losses if you meet the passive loss “material participation” rules that apply to all taxpayers for non-real estate losses.
To qualify as a real estate pro, you have to pass two tests:
– You have to spend at least 750 hours on your real estate activity, and
– You have to spend more time in your real estate business than you do on any other job you have.
The second test is usually impossible to pass if you have a non-real estate day job. But it can happen, as the Tax Court showed yesterday. The taxpayer husband, Mr. Miller, had a day job as a harbor pilot in San Francisco. He also had rental real estate property that Mrs. Miller helped him operate. Fortunately, piloting, while a skilled profession, seems to not be all that time-consuming:

At the age of 29, Mr. Miller became a partner in the San Francisco Bar Pilots Association (SFBPA) and began piloting commercial seagoing vessels for SFBPA.4 During the years at issue, Mr. Miller piloted client vessels for the SFBPA, including large container ships, passenger cruise ships and large military ships. He piloted these client vessels from 13 miles at sea, outside the San Francisco Bay Channel, throughout the San Francisco, San Pablo and Suisun Bays, including the Sacramento and San Joaquin Rivers.
Mr. Miller’s schedule as an SFBPA pilot requires that he work seven days and then have seven days off. Mr. Miller generally is not required to actually work for all of his seven days “on.” His schedule is also somewhat flexible and predictable. SFBPA pilots know roughly when they will have to work during their “on” time and can trade turns in the pilot rotation, subject to limitations.

That enabled him to throw himself into his real estate projects, and throw himself he did:

In addition to Mr. Bogart, other witnesses described Mr. Miller’s work ethic as extraordinary. A friend, pilot and partner of Mr. Miller’s at SFBPA testified to his “one in a million” work ethic, saying that he did not know anyone who worked harder. Mrs. Miller testified that she had to go to Mr. Miller’s construction sites to see her husband.

Wisely, Mr. Miller maintained records of his time, and he convinced the Tax Court that he met both the 750-hour and more-than-other-job requirements:

Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B).

But being a real estate pro is only the first step. Mr. Miller had to prove he “materially participated” in the loss activities. Mr. Miller passed that test for two of the activities, but not for four others:

Bennett Valley property for over 100 hours per year for the relevant years.10 We are also satisfied that their participation was not less than the participation of any other individual for those years. It follows, and we hold, that petitioners materially participated in the rental real estate activities at the Pepper Road property and the Bennett Valley property in the relevant years and the deductions attributable to those activities are not subject to limitation under section 469.
Petitioners have not shown, however, that they participated in the rental real estate activities at the Morning Glory property, the Lind property, the Price property or the Emerald property for over 100 hours per year for the relevant years.

The Moral: If you’re day job isn’t in real estate brokerage or development, you need a day job that isn’t very time consuming to qualify as a real estate professional. Then you have to work your butt off on your real estate work, and keep good records of your time.
Cite: Miller, T.C. Memo. 2011-219
Related: Being a ‘real estate professional’ only opens the door; it doesn’t carry you inside



Being a ‘real estate professional’ only opens the door; it doesn’t carry you inside

Tuesday, October 26th, 2010 by Joe Kristan

Real estate rental losses are by law “passive” to most taxpayers. That means they can only deduct the losses to the extent they have other “passive” income, or upon a sale. Taxpayers with AGI under $125,000 who “actively participate” in their rental activity may also deduct up to $25,000 in losses.
A special rule makes it easier for “real estate professionals” to deduct rental losses. If you qualify, real estate losses are non-passive if you meet the “material participation” tests that apply under the passive loss rules to non-real estate activities. But this rule doesn’t automatically make the losses deductible for real estate pros, as a California “real estate loan agent and broker” learned in Tax Court yesterday.
You can be a qualifying real estate professional if you pass two tests:
1. You spend at least 750 hours per year in real estate trades or business that you own, and
2. You spend more time in real estate businesses than in any other activities.
The judge explains the taxpayer argument:

Petitioner argues that because she is a qualifying real estate professional pursuant to section 469(c)(7)(B), all her real estate activities, including rental activities, are not passive and therefore she is not subject to the passive activity loss limitations.

Caselaw clearly requires that a taxpayer claiming deductions for rental real estate losses meet the “material participation” requirements of section 1.469-5T, Temporary Income Tax Regs., supra, even where the Commissioner has conceded that the taxpayer is a real estate professional pursuant to section 469(c)(7)(B).

The special rule for real estate pros just allows them to deduct rental loss if they “materially participate” in the real estate activity. Their losses are no longer automatically passive, but they do not become automatically deductible.
Cite: Perez, T.C. Memo 2010-232.
Related: Why I think the Tax Court judge got the passive loss 750-hour test wrong


Rental real estate: those don’t also serve who only stand and wait

Tuesday, September 21st, 2010 by Joe Kristan

The tax law “passive loss” rules limit “passive loss” deductions to the amount of “passive” income earned in a tax year, except when a “passive activity” is disposed of in a taxable sale. A special rule makes it worse for owners of rental real estate, which is always “passive” unless you qualify as a “real estate professional.” If you do qualify, then you can avoid the passive loss limits if you “materially participate” in the activity — a test based on how much time you spend on the activity.
The tax law says you have to meet two requirements to be a real estate pro:
– You have to spend at least 750 hours working in real estate trades or businesses, and
– You have to spend more time working in real estate than on any other activities.
A nuclear plant operator in New Jersey operated several rental properties on the side. The properties showed a loss on his joint 2007 return of $40,490, which he deducted in full as a real estate professional. The IRS looked at the return and disallowed the deduction attributable to his being a real estate professional (part of the loss was allowed anyway under a provision that allows some taxpayers with incomes under $150,000 to deduct part of a passive real estate loss) and asserted negligence penalties.
The taxpayer, a Mr. Moss, could only come up with 645.5 hours of work spent on the properties in 2007. But he could have worked more because he was “on call” in case something went wrong, as the Tax Court explained:

Essentially, petitioners claim that Mr. Moss could have been called to perform work at the rental properties at any time that he was not working at the Hope Creek plant, and, therefore, such on call hours should count toward meeting the 750-hour service performance requirement. We do not agree with petitioners’ contention that Mr. Moss’ “on call” hours may be used to satisfy the 750-hour service performance requirement. Section 469(c)(7) applies where the taxpayer “performs more than 750 hours of services”. Sec. 469(c)(7)(B)(ii) (emphasis added); see also sec. 1.469-9(b)(4), Income Tax Regs. (“Personal services means any work performed by an individual in connection with a trade or business” (emphasis added)). While Mr. Moss was “on call” for the rental properties, he could have been called in to perform services; however, these services were never actually performed by him. Accordingly, we conclude that Mr. Moss’ time “on call” for the rental properties does not satisfy any part of the 750-hour service performance requirement.

The court upheld the disallowance and the penalties.
The Moral? Coulda, woulda doesn’t get you far in Tax Court.
Cite: Moss, 135 T.C. No. 18
Related: Why I think the Tax Court judge got the passive loss 750-hour test wrong
Below: material participation basics.

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Iowa Capital Gain Deduction: an illustration

Tuesday, August 24th, 2010 by Joe Kristan

The Iowa Department of Revenue has posted a policy letter that nicely illustrates how Iowa’s “ten and ten” exclusion for capital gains works on the sale of a business.
Iowa’s capital gain exclusion applies on the sale of certain business property when a ten-year holding period and ten-year material participation requirement are met. The “material participation” rules are the same as the federal “passive loss” material participation rules, but with a special rule for “retired” farmers.
Flickr image courtesy cwwycoff1 under Creative Commons license
There are two separate exclusions:
– Capital gain on the sale of real estate used in the business qualifies for the exclusion if it has been held ten years, and if the taxpayer has materially participated in the business ten years, regardless of whether any other business assets are sold.
– All long-term capital gains incurred at the personal level on a sale of “substantially all of the assets” of a business meeting the ten-and-ten requirements qualify for the exclusion — even for individual asset that themselves have been held for less than ten years.