Posts Tagged ‘passive losses’

Tax Roundup, 3/26/15: Not every project is an “activity,” and why that’s a good thing. And: starting Iowa’s tax law fresh.

Thursday, March 26th, 2015 by Joe Kristan

What’s an activity? The tax law’s “passive loss” rules limit business losses when a taxpayer fails to “materially participate” in an “activity.” Whether an “activity” is “passive” is mostly 20150326-2based on the amount of time spent in the activity by the taxpayer. That can raise a tricky question: just what is an “activity?”

Many businesses do multiple things. Take a CPA firm that does tax and auditing. If those feckless auditors lose money, is that a separate “activity” from the hard-working tax side? Or consider a convenience store owner with two locations; is each a separate activity, or are they one big activity?

The Tax Court addressed this problem yesterday in a case involving a South Florida developer. Greatly simplifying a complex story of real estate backstabbing and inter-family rivalry, the problem was whether an S corporation was the same “activity” as a partnership with the same owners set up for s specific development project. If so, family patriarch Mr. Lamas could cross the basic 500-hour threshold for participation in the combined activity, making his losses deductible.

Judge Buch explains the IRS regulation (1.469-4(c)) governing this issue:

This regulation sets forth five factors that are “given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469″:

(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

This regulation further instructs that taxpayers can “use any reasonable method of applying the relevant facts and circumstances” to group activities, and that not all of the five factors are “necessary for a taxpayer to treat more than more activity as a single activity”.

Equality in action in the Soviet Union on the Belomor Canal

The judge said that Shoma (the S corporation) and Greens (the partnership) met these requirements, considering they had the same control and both were in the same general business. Also:

Finally, Shoma and Greens were interdependent. Greens operated out of Shoma offices, used Shoma employees, and consolidated its financial reporting with Shoma’s. Greens was formed by Shoma as a condominium conversion project. The shareholders intended that Greens be dissolved after the project was completed and the capital returned to its shareholders.

Because Shoma and Greens meet these five factors, we find that they are an appropriate economic unit and should be grouped as a single activity.

The taxpayer was able to satisfy the court through witness testimony and phone records that he met the 500-hour requirement.

This case is good news for developers, as this structure is common in that business: a permanent S corporation sets up new LLCs for each development project. This case correctly concludes that they are all part of the same development business.

Cite: Lamas, T.C. Memo 2015-59.


If Iowa's income tax were a car, it would look like this.

If Iowa’s income tax were a car, it would look like this.

Me, What an Iowa income tax might look like with a fresh start. My new post at, the Des Moines Business Record Business Professionals’ Blog, on what Iowa’s tax system might look like if we could start over. A taste:

A system designed from scratch would apply the ultimate simplification to Iowa’s corporation income tax: it wouldn’t have one. Iowa’s corporation income tax is rated the very worst, with extreme complexity and the highest rate of any state. 
Eliminating the corporation income tax would eliminate the justification for almost all of the various state incentive tax credits, all of which violate the principles of neutrality and simplicity in the first place. For its astronomical rates and complexity, it generates a paltry portion of the state’s revenue, typically 4-7 percent of state receipts.
For S corporations, a from-the-ground-up tax reform might tax Iowa resident shareholders only on the greater of distributions of S corporation income, or interest, dividends, and other investment income earned by the S corporations. The investment income provision would prevent the use of an S corporation as a tax-deferred investment. The effect would be to put S corporations on about the same footing as C corporations.

I have little hope in the legislature actually doing something sensible, but we have to start somewhere. I’d love to hear any thoughts readers may have.



Roger McEowen addresses the Tax Consequences When Debt is Discharged (ISU-CALT): “There are several relief provisions that a debtor may be able to use to avoid the general rule that discharge of indebtedness amounts are income, but a big one for farmers is the rule for ‘qualified farm indebtedness.'”

Russ Fox, A Break in my Hiatus: Poker Chips and Tax Evasion. Russ lifts his head from his tax returns to tell of the tax problems of a poker chip maker that he has personal experience with. “A helpful hint to anyone wanting to emulate Mr. Kendall: Just pay employees in the normal way, on the books, and send the withholding where it belongs.”

TaxGrrrl, Taxes From A To Z (2015): N Is For Nonrefundable Tax Credits

Robert Wood, Tax Fraud Draws 6 1/2 Year Prison Term Despite Alzheimer’s. Specifically, a dubious claim of Alzheimer’s.

Peter Reilly, Did Andie MacDowell’s Mountain Hideaway Require Tax Incentives? To listen to some people, you’d believe nothing good ever happened until tax credits were invented.




Jason Dinesen, Financing a Small Business, Part 5 of 5: Know When to Keep Quiet With the Banker. “Here are a couple of real-world examples I’ve seen where business owners got hung up with the bank because the owner wouldn’t stop talking.”

This has lessons for IRS exams, too.

Kay Bell, Obamacare, bitcoin add twists to 2014 tax filing checklist

Annette Nellen, Another Affordable Care Act Oddity. “Perhaps the problem is more tied to the “cliff” in the PTC that causes someone to completely lose the subsidy once their income crosses the 400% of the FPL (more on that here).”

William Perez, How Much Can You Deduct by Contributing to a Traditional IRA?


Alan Cole, Richard Borean, Tom VanAntwerpWhich Places Benefit Most from State and Local Tax Deductions? (Tax Policy Blog):



The short answer? Places with high state tax rates and high-income earners. Note the purple spot right in the middle of Iowa.


TaxProf, The IRS Scandal, Day 686

Renu Zaretsky, Sense and Sensibilities. Today’s TaxVox headline roundup covers the House GOP budget, a Texas tax cut, and tax-delinquent federal employees.


Richard Phillips, How Presidential Candidate Ted Cruz Would Radically Increase Taxes on Everyone But the Rich (Tax Justice Blog). A taste:

On the flat tax, Cruz has not yet spelled out a specific plan that he would like to see enacted, but it’s unlikely that any plan he proposed will be significantly better than the extremely regressive flat tax proposals that have been offered in the past.

Or, “we don’t know what he will do, but it will be terrible!”


Caleb Newquist, Big 4 Gunning for Big Law. To steal a cheap line: who wins if the Big 4 and Big Law fight to the death? Everybody!


Tax Roundup, 11/20/14: ACA and filing season pessimism revisited.

Thursday, November 20th, 2014 by Joe Kristan

Programming note: The Tax Update will take tomorrow off. I will be in Phoenix tomorrow on a panel on state film tax credits sponsored by the National Conference of State Legislators.  The panel will include, among others, Joseph Henchman of the Tax Foundation. Normal programming resumes Monday.


guillotineACA frenzy! Thanks to a kind Twitter mention from Megan McArdle (who you really should follow at @asymmetricinfo), my Tuesday post on ACA and filing-season dread made it to a wider audience than usual, including the readers of Real Clear Politics. A cousin who I normally only see at family weddings and funerals saw it and sent me a note (Hi, Bob!), so I know it really got around.

It has also generated questions in the comments and the Twitterverse that are worth addressing. We’ll start with this from Alan in the comments:

In a few months when people receive their W2’s they will get a real shock when all the employer paid share of the company paid share of health care plan is included in their gross pay and now they must pay taxes on all that extra income.

Obamacare is ugly, but it isn’t that ugly. While many (but not all) employers will disclose the cost of coverage on W-2 box 12 (code DD), it will not be included in W-2 Box 1, “taxable wages.” From, Employer-Provided Health Coverage Informational Reporting Requirements: Questions and Answers:

Q1. Does the cost of an employee’s health care benefits shown on the Form W-2 mean that the benefits are taxable to the employee?

A. No. There is nothing about the reporting requirement that causes or will cause excludable employer-provided health coverage to become taxable. The purpose of the reporting requirement is to provide employees useful and comparable consumer information on the cost of their health care coverage.

20121120-2From Ms. McArdle on Twitter:

Any chance it won’t be that bad?

I suppose that depends on what “that bad” means. Blood seeping from the walls, shape-shifting brain-eaters from Planet Zargon, cats and dogs living together– probably not that bad. But there’s still plenty of bad to go around. The things that worry me:

- Many taxpayers will not have the information handy to determine their health insurance status for all 12-months of 2014. Only those who buy insurance on the exchanges will have Form 1095, the information return on insurance status.  Others are supposed to get information from employers, but they are likely to lose track of it, especially this first year.

- Lacking any matching documents, taxpayers will be tempted to claim coverage where there is none, or maybe wasn’t for part of the year, to avoid penalties. There won’t be an easy way to verify this. Preparers will either have to take taxpayers at their word or send them back for proof (or, inadvertently, to another preparer). It’s always bad when taxpayers feel they should lie to preparers. Yet as the IRS will often have no way to detect false claims of coverage, they will feel like chumps for telling the truth.

- Taxpayers with penalties for non-coverage will be irate when they find they get no refund. As Ms. McArdle wisely put it, “I do not have hard figures on this, but my basic experience in personal finance and tax reporting suggests that approximately zero percent of those affected will be expecting the havoc it will wreak on their tax refund.” Experience shows that the taxpayer’s first instinct is that the preparer screwed up.

- It will be even worse when we have to tell people to repay advance health-care tax credits paid to insurers to lower consumer out-of-pocket costs. This can happen when actual taxable income exceeds the amounts estimated when coverage was obtained on the exchanges. As the taxpayer never “saw the money” — it was paid to the insurer, not to the taxpayer directly — she may not be easily convinced that she has an excess benefit to repay.

20140521-1- Preparers haven’t had to deal with this before. Any new tax provision has a learning curve, and this is a complicated one that will apply to almost everyone. In many cases, preparers will mess up, being human. Getting it right will take extra time that is hard to come by during tax season.

- This doesn’t even touch the problems that many small employers are going to be dealing with as they realize their Section 105 individual coverage premium reimbursement plans, and their cafeteria plans funding premium payments on individual policies obtained by employees, are considered non-compliant under the ACA “market reforms.” At $100 per employee, per day, the penalties could be ruinous. While taxpayers are encouraged to report the penalties on Form 8928 and zero them out with a “reasonable cause” claim, we don’t know yet how generous the IRS will be in granting reasonable cause relief. Figuring out what to do here will be time-consuming and nerve-wracking for taxpayers and preparers, unless the IRS issues a blanket penalty waiver for 2014 (as it should).

On top of all this, we will probably have another late “extender” bill like we had two seasons ago, which made for an awful tax season by itself. Maybe things will go well this season, but so many things seem likely to go wrong that it’s hard to be optimistic.


Tony Nitti, The Top Ten Tax Cases (And Rulings) Of 2014: #6-The IRS (Finally) Figures Out The Real Estate Professional Rules. It’s an excellent lesson on the tax rules covering “real estate professionals” and passive losses — and by extension, the 3.8% net investment income tax.

TaxGrrrl, Al Sharpton Denounces Claims He Owes Millions In Taxes To IRS, New York.

Jack Townsend, Another UBS/Wegelin Related Indictment in SDNY

Peter Reilly, Kent Hovind And Creation Science Evangelism – How Not To Run A Ministry. When it gets you imprisoned, you may well be doing it wrong.

Kay Bell, Former GOP VP candidate Paul Ryan to head House tax panel

Jason Dinesen, I Don’t Have Time to Write Grant Proposals or Meet with Donors … But Give Me Money Anyway!  OK, then…


Work proceeds in clearing the ruins of the Younkers department store, which burned in March.


TaxProf, The IRS Scandal, Day 560.

Cara Griffith, Bad News for State Public Pension Plans (Tax Analysts Blog). “New research has come out revealing the level at which state public pension plans are underfunded, and it’s not good news.”

The denial of reality in administering public pensions is amazing. Public defined benefit plans are a lie. Either the public is being lied to about how much current public services cost, or current employees are being lied to about their retirement benefits. Maybe both.


20140910-1Alan Cole, Extenders and the Opportunity for Tax Reform (Tax Policy Blog):

The Examiner characterizes many of the extenders as “repugnant carve-outs.” This is undeniably true, but it is also the case that some – but not all – of the tax extenders are genuinely good policy. Particularly, Bonus Depreciation and Section 179 are important for moving the tax code towards proper treatment of new investment.

In any case, the current system of pretending tax provisions are “temporary” to hide their true cost is dishonest and should end.

Renu Zaretsky, “Dead Reform Walking:” On Fairness, Immigration, and Spending. The TaxVox headline roundup covers developments in the Marketplace Fairness Act, extenders and immigration, among other things.


News from the Profession. KPMG Gives the Department of Homeland Security a Clean Audit Opinion Because of Course They Did (Adrienne Gonzalez, Going Concern). “I don’t know about you but I feel safer already.”



Tax Roundup, 8/21/14: IRS says saving the company still “passive;” Tax Court says otherwise And: the $105.82 c-note!

Thursday, August 21st, 2014 by Joe Kristan

Programming note: No Tax Roundup will appear tomorrow, August 22.   I will be up in Ames helping teach the ISU Center for Agricultural Law and Taxation class “Affordable Care Act (ACA): What Practitioners Need to Know in the morning.  Webinar registration is closed, but you can still  attend as a walk-in.


S imageS imageS-SidewalkYou saved the company.  Big deal.  Apparently pulling the company you started from the brink of failure wasn’t enough to convince the IRS that a taxpayer “materially participated” and could deduct losses on his tax return.

Charles Wade was a founder of Thermoplastic Services, Inc. and Paragon Plastic Sheeting, both S corporations.  After his son Ashley took over daily management of the business, he still owned a significant stake in the company.  He never really retired, though.  From the Tax Court (my emphasis, footnotes omitted in all Tax Court quotes):

With Ashley there to handle day-to-day management, Mr. Wade became more focused on product and customer development. He did not have to live near business operations to perform these duties, so petitioners moved to Navarre, Florida. After the move he continued to make periodic visits to the facilities in Louisiana and regularly spoke on the phone with plant personnel.

In 2008 TSI and Paragon began struggling financially as prices for their products plummeted and revenues declined significantly. Mr. Wade’s involvement in the businesses became crucial during this crisis. To boost employee morale, he made three trips to the companies’ industrial facility in DeQuincy, Louisiana, during which he assured the employees that operations would continue. He also redoubled his research and development efforts to help TSI and Paragon recover from the financial downturn. During this time Mr. Wade invented a new technique for fireproofing polyethylene partitions, and he developed a method for treating plastics that would allow them to destroy common viruses and bacteria on contact. In addition to his research efforts, Mr. Wade ensured the companies’ financial viability by securing a new line of credit. Without Mr. Wade’s involvement in the companies, TSI and Paragon likely would not have survived.

Slacker.  At least according to the IRS, who said that this participation failed to rise to the level of “material participation” and disallowed over $3 million in pass-through losses on Mr. Wade’s return.

The Tax Court took a different view.  Judge Goeke explains :

A taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances * * * the individual participates in the activity on a regular, continuous, and substantial basis during such year.” A taxpayer who participates in the activity for 100 hours or less during the year cannot satisfy this test, and more stringent requirements apply to those who participate in a management or investment capacity.  The record reflects that Mr. Wade spent over 100 hours participating in TSI and Paragon during 2008, and his participation consisted primarily of nonmanagement and noninvestment activities. Ashley managed the day-to-day operations of the companies; Mr. Wade focused more on product development and customer retention.

Although Mr. Wade took a step back when Ashley became involved in the companies’ management, he still played a major role in their 2008 activities. He researched and developed new technology that allowed TSI and Paragon to improve their products. He also secured financing for the companies that allowed them to continue operations, and he visited the industrial facilities throughout the year to meet with employees about their futures. These efforts were continuous,  regular, and substantial during 2008, and we accordingly hold that Mr. Wade materially participated in TSI and Paragon. 

20120801-2It’s notable that the judge did not require Mr. Wade to produce a daily log.  Apparently there was enough testimony and evidence to show that his participation crossed the 100 hour threshold.

The 100 hours might not have been considered enough under some circumstances.  Usually the IRS holds taxpayers to the default 500-hour test for material participation.  This case is unusual in its use of the fall-back 100-hour “facts and circumstances” test. It’s good to see the Tax Court use it, as the IRS seems to think this test never applies.

It’s also interesting that the efforts at “customer retention” were counted.  This could be useful in planning for the 3.8% Obamacare Net Investment Income Tax.  The NIIT taxes “passive” income, defined the same way as the passive loss rules.  A semi-retired S corporation owner who still calls on some of old accounts after turning daily operations over to successors might be able to avoid the NIIT under the logic of this case.  If so, though, it would be wise to keep a calendar to prove it.

Cite: Wade, T.C. Memo. 2014-169


Russ Fox, A Passive Activity Case Goes to the Taxpayers.  “Hopefully the IRS can get more of these cases right at audit and appeals–they’ll be dealing with many more of these over the coming years.”

Paul Neiffer, More than 100 but Less than 500.  “It is nice to see that a subjective test went in the taxpayer’s favor.”

Material participation basics.


How far does $100 go in your city?  Last week the Tax Foundation issued a map showing how far $100 goes in different states.  Now they have issued a new map in The Real Value of $100 in Metropolitan Areas (Tax Policy Bl0g).  It is wonderful — just scroll your cursor over your town.

In Des Moines, $100 is good for $105.82.  In New York, it gets you $81.83.


TaxGrrrl, Anna Nicole Smith’s Estate Loses Yet Another Run At The Marshall Fortune

Tony Nitti, Could The IRS Disallow Ice Bucket Challenge Charitable Contributions?  Go ahead, IRS, just try it.  You’re just too popular.

William McBride, Earnings Stripping, Competitiveness, and the Drive to Further Complicate the Corporate Tax (Tax Policy Blog)

Roberton Williams, One Downside Of Inversions: Higher Tax Bills For Stockholders (TaxVox)

Kay Bell, How does the U.S. corporate tax rate compare to other countries?  Poorly.

TaxProf, The IRS Scandal, Day 469


David Brunori, Using Local Cigarette Taxes for Schools Is Silly (Tax Analysts Blog).  Smoke ‘em if you got ‘em.  For the children!

Cara Griffith, Was Oregon’s Tax Incentive Deal With Intel Unnecessary? (Tax Analysts Blog).  No, it was absolutely necessary to enable the Governor of Oregon to issue this press release and YouTube announcement.  That’s the point, after all.



The United States gets little tax from Americans overseas today. Most of them live in high-tax countries and have no U.S. income tax in any event because of FTCs and the section 911 foreign earned income exclusion. But as we all know, Congress couldn’t care less about this subject, and this is all a non-starter. Better to place your money on a genetically modified flying pig.

Robert L. Williams in Tax Analysts ($link)



Tax Roundup, 2/13/2013: The President wants more taxes. Because they’re doing such a good job with what they get now.

Wednesday, February 13th, 2013 by Joe Kristan

State of the union:  raise taxes more.  It will never be enough.  If you think we don’t have a spending problem, or think we can solve it through “closing loopholes,” check out three charts gathered by Veronique de Rugy:



The President proposes nothing serious.

Breaking news from yesterday: Look for a Call to End Oil “Subsidies” in Tonight’s State of the Union (Andrew Lundeen, Tax Policy Blog)

Howard Gleckman, Obama’s State of the Union and the Great Deficit Smackdown (TaxVox)


How H&R Block guy got to write preparer regs.  Civil Service! Tim Carney reports:

In 2009, the Obama administration hired Mark Ernst, the previous CEO of tax prep giant H&R Block, as IRS deputy commissioner. Ernst became a “co-leader” (in the words of an IRS spokesman) in drafting new regulations for tax preparers.

This seems to clash with President Obama’s executive order barring appointees from working on regulations directly affecting their former employers.

But thanks to a fine legal distinction, these rules didn’t cover Ernst. “Mark Ernst is a civil servant at the IRS; he is not a political appointee,” an IRS spokesman wrote me. “The Presidential Executive order on Ethics Commitments by Executive Branch Personnel only applies to political appointees.”

Nobody here but us chickens.


Jason Dinesen has a new installment about his client whose identity was stolen in the ID theft epidemic that really got rolling while the IRS was busy regulating preparers.  “If you hired the best comedy writers and satirists in Hollywood, they couldn’t come up with a more farcical script about government ineptness.”

Speaking of government competence:

Not only will most farmers have to file after March 1, 2013 due to a delay in tax forms by the IRS, we  now have an announcement that almost all form 1099s issued by the USDA for Natural Resources Conservation Services payments in 2012 are either wrong or were never issued.

via Paul Neiffer.


David Brunori, If You Hate or Love Excise Taxes Read this New Report:

A new working paper  recently released by the Mercatus Center at George Mason University… finds that contrary to conventional wisdom, sin taxes are often not used to correct externalities but rather for general fund spending. My take on that is politicians don’t really care about externalities. They would like to raise money from people whose activities they despise. The report also found that the goal of “sin taxes” has changed from correcting market failures to protecting consumers from their own choices. That is, people are too stupid to run their own lives and they need help. Finally, the report finds that sin taxes are regressive, i.e., they punish the poor. Unfortunately, my liberal friends never get exercised over this issue. Maybe it’s as the great PJ O’Rourke surmised, liberals hate poor people. 

If they would just not wear those icky Wal-Mart clothes and watch their weight, like they tell them to… (


Peter Reilly,Even Real Estate Salesman Has Trouble With Passive Loss Exception

Even accepting that he spent 520 hours working on his own properties, he still lost.  Two of the properties were short-term vacation rentals and one was being readied for sale.  The time spent on those properties could not be grouped with the time spent on properties dedicated to long term rentals.

As Peter notes, this becomes an even more important tax issue with the new 3.8% tax on “passive” income this year.


Kay Bell,  When will you get your tax refund? Whenever

Trish McIntire, Child Tax Credit Delays

TaxGrrrl, Spammers Target Taxpayers Expecting Tax Refunds.  If you get an email about your refund from the IRS, it’s not from the IRS.

Jack Townsend, Another Bull**** Tax Shelter Bites the Dust

Roger McEowen, Another Court Issues Ruling on Tax Impact of Demutualization.

Tax Trials,  Second Circuit: Co-Op Owner Is Entitled to Casualty Loss

Patrick Temple-West, Navigating between tax avoidance and evasion, and more

Gene Steurle, Desperately Needed: A Strong Treasury Department (TaxVox)

Robert Goulder, La Bella Italia: Fast Cars & Loose Taxes (

Jim Maule, When Spending Cuts Meet Asteroids: The Value of Taxes.  Taxes and spending can never be too high because, you know, asteroids!

The Critical Question.  Minnesota’s Sexiest Accountant Contest: Cute or Creepy? (Going Concern)



Tax Court keeps taxpayer mistake from triggering the “self-rental” passive income rule.

Wednesday, November 14th, 2012 by Joe Kristan

Cell tower image courtesy Wikpedia Commons

The tax law “passive activity” rules were written to shut down real estate shelters by making rental losses “passive,” deductible only to the extent of “passive” income.  About 3 seconds after the rules were enacted, taxpayers began thinking of ways to generate passive income so they could deduct their passive losses by renting land or by renting property to a controlled business activity.  Rules treating “land rent” or “self-rental” net income as non-passive were issued quickly to stop that.

The new Obamacare 3.8% tax on “investment income” will apply to “passive income” as determined under the passive loss rules, so a  Tax Court decision issued yesterday exploring these issues takes on added importance.

The taxpayer leased land with cell-phone towers to his wholly-owned S corporation.  The S corporation in turn leased the towers to phone companies.  The taxpayer also leased land to his S corporation.

The S corporation mistakenly reported the income from its leases to the phone companies as ordinary income, rather than rental income, lumping the tower rental with the S corporation’s other business income.  The taxpayer treated the income as non-passive.

The towers leased to the S corporation were reported as passive leases on the taxpayer’s 1040, as were the land rents.  Some tower leases were profitable while others generated losses, but because they were all reported as “passive,” the losses and income offset.

The IRS had other ideas. The IRS left the K-1 income as non-passive, saying that the leases to the phone company wasn’t really “rental,” and in any case the taxpayer was stuck with the way the income was reported.  The IRS split the income from “self-rental” of the towers to the controlled corporation,  with the losses treated as passive and the income reclassified as non-passive under the self-rental rules.   The bottom line: a lot of non-passive income that couldn’t be offset by the now non-deductible passive losses.

The Tax Court said the IRS was being too cute.  The IRS said that the taxpayer was bound by his treatment of the S corporation tower income as non-passive because he had already grouped it with his other activities.   Judge Halpern said the IRS regulations didn’t have to cause such a harsh result.  While the taxpayer might be stuck with its return reporting for determining whether to report income from the K-1 as passive, that didn’t extend to the self-rental rules. so the taxpayer didn’t have to split up the cell-tower rental to the S corporation between profitable (non-passive) and loss-generating (passive):

We recognize that, because ICE erroneously reported all of its income as ordinary business (non-passive-activity) income, nonapplication of the self-rental rule of section 1.469-2(f)(6), Income Tax Regs., to ICE’s rental payments to petitioner, in effect, results in the reduction of what was reported as “active business income” and the offsetting creation of “passive income” in seeming contravention of the congressional conferees’ directive to issue regulations preventing that result. See H.R. Conf. Rept. No. 99-841 (Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147. We do not believe, however, that ICE’s tax return mischaracterization of its tower access rental income from third parties should control the application of the self-rental rule where, as here, it is, by its terms, inapplicable, i.e., where petitioner’s towers were not, in fact, used in a trade or business. Moreover, we are not persuaded that the result we reach herein violates the conferees’ directive as it does not, in fact, permit “passive income” to offset “active business income”.

The Tax Court upheld the IRS in treating the land-rental as non-passive.

The Moral?  The Tax Court reached a fair result, even though it had to stretch around the regulations to do so.  Had the towers been rented to the S corporation for use in its non-passive business, the judge would probably have given the IRS its “heads I win, tails you lose” treatment — the income would have been non-passive, and the losses would have been passive and non-deductible.  The result was different because the S corporation in turn leased the properties to third parties, instead of using them in its non-passive business.

The result is fair because the taxpayer isn’t really generating improper passive income that wouldn’t be there if it had reported the income on the K-1 properly in the first place.

This case reminds us how important it is to identify your passive activities and group them properly.   With the 3.8% tax on passive income taking effect in January, this is even more important.

Cite: Dirico, 139 T.C. No. 16.


“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.


Understanding your partnership K-1: can you deduct that loss?

Tuesday, April 3rd, 2012 by Joe Kristan

Flickr image by naotakem under Creative Commons licenseLife is always easier when you’re making money.  The problems of prosperity are much more pleasant than those of poverty.  That’s also true when your partnership is losing money. 

Yesterday we showed how a K-1 works.  Today we cover the special problems of K-1s that show losses.  Just as the owners of a partnership pay income taxes on partnership income, they get to deduct the losses, too, right?

It depends.  There are three hurdles that a K-1 recipient has to clear to deduct K-1 losses. 

The first hurdle is basis. Your basis starts with your investment in the K-1 business; it is increased by income and cash contributions and decreased by losses and distributions. In partnerships  — but not S corporations — an owner’s basis may include a portion of the company’s borrowings from third parties.

Unfortunately, the K-1s do a poor job of tracking owner basis.  You, or your tax preparer, may need to keep a separate schedule of your basis to determine whether you might deduct K-1 losses.

The next hurdle is whether your basis is “at-risk.” The “at-risk” rules are an obscure leftover of tax shelter battles of the 1970s, but they still apply.They can be very complex, but their gist is that if your basis is attributable to borrowings that are “non-recourse” — that you aren’t personally liable for — it is not “at risk,” and losses attributable to that basis must be deferred. You may also not be considered “at risk” for related-party borrowing, especially if you borrow from your business or from a business associate to fund your ownership in the K-1 issuer.

Partnership K-1s provide some useful information in determining whether you have an “at-risk” issue. If you have losses in excess of your cash investment, and your share of debt on the K-1 part K is on the “nonrecourse” line, you are likely to have an at-risk problem. You will have to go to IRS Form 6198 to figure out whether you have to defer losses under the at-risk rules.

The “passive loss rules” are the final hurdle for deducting K-1 losses. These rules were enacted in 1986 to shut down that era’s tax shelters. If you have “passive” losses in excess of “passive” income, you have to defer the losses until you have passive income in a future year, or until you dispose of the “passive activity” in a taxable transaction.

A loss is “passive” if you don’t “materially participate” in the business. There are a number of tests that you can use to determine whether you materially participate, but the most common is working at least 500 hours in the business in a year. 

Real estate rental is passive by law, unless you are a “qualifying real property professional.”  Special rules keep you from generating “passive” income to allow you to deduct passive losses. For example, land rent and most investment income is not considered “passive” under these rules. The passive loss limitation is computed on Form 8582.

These rules are complicated, even for tax pros. If you aren’t sure where you stand, and the losses are significant to you, get in touch with a tax pro.

A version of this item previously appeared at


You want to deduct that loss? Be ready to prove you are non-passive

Thursday, January 19th, 2012 by Joe Kristan

A Tax Court case yesterday illustrates the problems taxpayers with day jobs face when they want to deduct losses for side activities. A Minnesota entrepreneur named Alfred Iverson, who founded a successful manufacturer of surgical and medical equipment, also had a 14,000 Colorado ranch where he raised Angus and Herford cattle. The ranch generated tax losses in 2005 and 2006, and the couple deducted the losses.
The IRS challenged the losses, saying they are “passive” under the tax law. The taxpayers failed to convince the Tax Court that they spent enough time in farm activity to deduct the losses. From the Tax Court opinion:

Petitioners claim that in each of 2005 and 2006, whether at the ranch in Colorado or from petitioners’ home in Minnesota, Mr. Iversen spent a total of at least 400 hours working on matters relating to Stirrup Ranch, Mrs. Iversen spent at least another 100 to 150 hours working on matters relating to the horses at the ranch, and that they together meet the 500-hour test of section 1.469-5T(a)(1), Temporary Income Tax Regs.

Our analysis of the time and activity petitioners spent in 2005 and 2006 working on matters relating to Stirrup Ranch is made difficult by the lack of meaningful contemporaneous or other records and documentation regarding specifically what petitioners did on a day-to-day basis and how much time they spent on matters relating to Stirrup Ranch. In this case, the lack of records and documentation are not cured by estimates made years after the fact in writing or by testimony.

It’s up to the taxpayers to prove that they spent enough time on an activity for it to be non-passive. The taxpayers didn’t produce enough time sheets or other records to convince the judge.
The passive loss rules could take on much more importance if the “Affordable Healthcare Act,” or “Obamacare,” remains on the books. The law imposes a 3.8% additional tax on “passive” income starting in 2014. Obamacare defines “passive” using the passive loss rules. At a D.C. bar luncheon yestreday, practitioners noted that this could be a big problem for S corporations ($link)

Unless S corporations begin planning for the tax, shareholders “will be short” when it comes time to pay their taxes, especially those who have passive positions in those passthroughs, he said.
Coupled with a potential increase of the income tax back to 39.6 percent for the highest bracket, the Medicare contribution tax could pose significant problems for S corporations, which must maintain a single class of stock requirement, [Brian] O’Connor said. As a result, the S corporations must “distribute the same amount to everyone,” he said, adding, “So that essentially means that more money is going to be coming out of the company.”
If the income tax rates do rise to pre-Bush era levels, the effect will be “dramatic,” O’Connor said.

The moral? Entrepreneurs with loss activities are wise to keep track of their time daily. Absent AHCA repeal, all entrepreneurs will need to become time trackers.
Cite: Iversen, T.C. Memo 2012-19



It’s hard to be a real estate professional

Friday, January 13th, 2012 by Joe Kristan

It’s been a rough run in recent years for folks in the real estate game, for non-tax reasons. The tax law doesn’t make it easy to be a real estate professional either, as a Pennsylvania man learned yesterday from the Tax Court.
The tax law’s “passive loss” rules only allow you to deduct “passive” losses to the extent of passive income, except when you dispose of the activity in a taxable sale. For most taxpayers, rental real estate losses are automatically passive under the tax law. For non-real estate activities, the tax law determines whether you are passive based on the extent of your participation in the business.
“Real estate professionals” have a special deal. Their real estate losses aren’t automatically passive; they are instead tested under the usual “material participation” standards. That makes everyone want to be a real estate pro, at least on their tax returns. Unfortunately the tax law doesn’t make it easy to be a real estate pro. To qualify, you have to:
- Spend at least 750 hours per year participating in a real estate trade or business that you own, and
– You have to spend more time on real estate activities than other activities.

The second requirement makes it very difficult for anybody with a full-time non-real estate job to be a real estate pro under the tax law. It was too high a bar for Mr. Vandergrift from Pennsylvania (citations omitted; my emphasis):

Petitioners maintain Mr. Vandegrift qualifies as such an individual. He testified that over one-half of the total time he spent in business activity was devoted to the real estate business. We found Mr. Vandegrift to be generally honest and forthright, but his time estimate is suspect given his employment as a salesman for an employer in a business unrelated to the real estate activity. His subjective estimate also suffers from a lack of contemporaneous verification by records or other evidence.

We have held that the regulations do not allow a postevent “ballpark guesstimate” of time committed to participation in a rental activity. We are forced to find on the record before us that petitioners have failed to carry their burden of establishing that Mr. Vandegrift spent over one-half his work time in the real estate business.

The only case I’ve seen where a taxpayer with a full-time day job qualified as a real estate professional had two unusual facts: A cushy day job that didn’t require a lot of time, and a taxpayer who kept meticulous time records. Absent those facts, someone with a non-real estate day job is probably not going to qualify as a real estate pro under the passive loss rules.
Cite: Vandegrift, T.C. Memo. 2012-14


It’s a long way from Milan, Minnesota to Nuremberg

Tuesday, December 20th, 2011 by Joe Kristan

A Minnesota banker-attorney has explored an unorthodox approach to tax : invoking the Nuremberg laws. Tax Court judge Holmes explains:

Erik Thompson didn’t file returns for tax years 2004 and 2006 because he disapproved of the wars in Iraq and Afghanistan and didn’t want to fuel “the government’s killing machine.” The Commissioner sent him a notice of deficiency, and Thompson filed a petition. He didn’t approach pretrial preparation in the spirit of cooperation that our Rules hope to inspire, because he saw “little distinction between the activities of the IRS and Tax Court and the activities of those good law-abiding Germans who drove the trains to the death camps.”

The IRS wasn’t persuaded by the analogy, and perhaps the taxpayer wasn’t either, as he began to change his approach:

He began to back off from such sentiments at trial and brought with him numerous documents that he’d never shared with the Commissioner. We reserved decision on the Commissioner’s motion to exclude this evidence, and Thompson eventually collaborated with the Commissioner to settle many issues. Two remain for both years in issue: (1) investment-interest expense and (2) rental-real-estate loss. The Commissioner says Thompson didn’t substantiate the former and didn’t participate actively enough in the rental real-estate activity to get the latter.

The IRS didn’t raise the issue of whether the losses were passive until trial, which led the banker-attorney taxpayer to protest that the IRS failed to raise the issue on a timely basis. The judge found that the IRS had some good reasons:

The Commissioner argues that “petitioner was not able to establish that the rental activity was non-passive or that the activity was engaged in for a profit.” Showing unusual chutzpah, Thompson blames the Commissioner for waiting too long to raise the issue of character of the losses. (At trial Thompson focused on the amount of the loss.)
It’s true that if an issue is untimely raised — unfairly surprising the opposing party by not giving him a chance to adequately address it at trial — we’ll refuse to consider it. Rolfs v. Commissioner, 135 T.C. 471, 484 (2010) (citing prior caselaw). But we disagree with Thompson’s premise. The Commissioner didn’t raise this issue for the first time on brief; he raised it at trial. (And considering Thompson hadn’t bothered giving the Commissioner anything relating to his deductions and losses until one week before trial, this was no small feat.)

The only way for the losses to be non-passive would be either:
– if the taxpayer met the “active participation” rule that allows up to $25,000 of rental losses to be deducted, a provision that phases out as AGI exceeds $100,000; or
– If the taxpayer met the “rental real estate professional tests (750 real estate hours and more than any non-real estate activities) AND materially participated in the real estate activity under the usual material participation tests.
Judge Holmes found he failed to meet the tests. Apparently the taxpayer brought his banking into the argument:

Thompson also makes “fairness” arguments concerning the Prairie losses. First he argues that because he believes Milan Agency, Inc., and Prairie [the rental business] are grouped together under banking law, they should be grouped together for tax law (and thus, we suppose, gains and losses of the two should be netted). But grouping for tax law — at least for the purpose of applying the passive-activity loss rules — is defined under section 1.469-4, Income Tax Regs., which doesn’t cross-reference banking law.

Fairness, of course, has nothing to do with the passive loss rules.
Cite: Thompson, T.C. Memo. 2011-291


Rental home deduction disaster

Tuesday, October 18th, 2011 by Joe Kristan

When a school assistant principal took a new job in Minnesota, she held on to her house outside Kansas City and tried to lease it. Her tale as told in Tax Court yesterday provides lots of lessons in deducting rental losses.
Because she had adjusted gross income under $150,000′ she didn’t have to pass the difficult test of being a “real estate professional” to deduct her losses. She had to meet the much lower “active participation” test. The judge said she did:

The active participation standard can be satisfied without regular, continuous, and substantial involvement in an activity; the standard is satisfied if the taxpayer participates in a significant and bona fide sense in making management decisions (such as approving new tenants, deciding on rental terms, approving capital expenditures) or arranging for others to provide services such as repairs. Madler v. Commissioner, T.C. Memo. 1998-112.
In the instant case, it is clear that petitioner owns the Kansas City house and that she is the one who is not only responsible for making all management decisions but who in fact makes such decisions. We therefore find that petitioner satisfied the active participation standard in 2006 and 2007 and is therefore entitled to offset her nonpassive income for 2006 and 2007 by her substantiated rental losses, subject to the phaseout limitation (potentially applicable only in 2007).

The judge stressed the substantiation requirement for a reason. The court found that the taxpayer kept less than meticulous records, using excuses that she might have heard from wayward children in her school:

In the instant case, the documentary evidence regarding the disputed deductions is relatively scant. At trial, petitioner testified that she kept her tax records in the basement of her home in Minnesota and that the basement was flooded on three separate occasions, once when a sump pump failed, once when her hot water tank failed, and once after “a big storm”, which “soaked” certain of her records, prompting her to throw them out. However, it remains unclear why petitioner could not have reconstructed at least some of her records by contacting third-party payees, such as insurance and utility companies. Indeed, at trial, petitioner did not testify that she made serious attempts to do so.

The judge estimated some of the unsubstantiated deductions under the “Cohan Rule'” but the travel expenses for trips to the home failed the strict travel substantiation rules and were fully disallowed. The court allowed about $13,000 of the $25,000 deductions claimed and imposed a 20% penalty on the taxes owed.
The moral? Keep good records, and watch out for high water.
Cite: Bonds, T.C Summ. Op. 2011-122


Tax Court: no matter how bald you are, your head isn’t real estate

Wednesday, October 12th, 2011 by Joe Kristan

There’s a superficial similarity between real estate management and barbering. Real estate managers have to keep the grass trimmed, and barbers have to keep the hair trimmed. That similarity didn’t help a California barber get his real estate deductions in Tax Court yesterday.
The “passive loss” rules only allow you to deduct “passive” losses to the extent of “passive” income. For most businesses, you are “passive” unless work enough in the business to “materially participate.” Real estate rental losses are a special case. For most taxpayers, they are automatically passive. If you are a “real estate professional,” however, then you can be non-passive if you “materially participate,” like in any other business.
The tax law makes it hard to be a real estate pro. You have to pass two tests:
– You have to work more than 750 hours in real estate trades or businesses, and
– You have to work more in those businesses than you do in any other business.
The second test makes it hard for those with day jobs to qualify. The barber, a Mr. Ani, failed to convince the Tax Court that he passed that test. From the opinion:

With respect to the two documents Mr. Ani’s accountant prepared, the first document was prepared as a sampling of the types of activities that could take place but was not complete enough to establish hours for each activity. The second document provided sufficient detail with respect to hours spent on the barber and real estate activities when coupled with Mr. Ani’s testimony. According to the second document, Mr. Ani spent a total of 1,377 hours performing barber services and 956 hours managing petitioners’ rental properties in 2005, and 1,380 hours performing barber services and 886 hours managing petitioners’ rental properties in 2006. Thus, Mr. Ani spent more time in 2005 and 2006 working as a barber than he did managing petitioners’ rental properties.

Decision for IRS.
While it is difficult for somebody with a non-real estate day job to qualify as a real estate pro, it has been done.
Cite: Ani, T.C. Summ. Op. 2011-119
To learn what “material participation means, read more.



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



Farm Buildings and 100% bonus depreciation

Friday, August 12th, 2011 by Joe Kristan

Paul Neiffer summarizes:

If a farmer is constructing a new building and the construction commenced after September 8, 2010 and is finished before January 1, 2012, then the total cost is allowed to be 100% depreciated during 2011. If the building construction commenced before September 9, 2010 and was finished in 2011, then only 50% bonus depreciation is allowed (unless you can segregate out some components that can be 100% bonus depreciated this year).

This only applies to farm buildings. Non-farm residential or commercial real estate is not eligible for bonus depreciation, with a very limited exception for some restaurant buildings. If the bonus depreciation generates a loss, the usual rules limiting losses may apply — basis limitations, at-risk rules, and the passive activity loss rules.


More on grouping passive losses

Tuesday, May 31st, 2011 by Joe Kristan

The IRS last week issued guidance on electing to treat all rental real estate activities as a single activity. Roger McEowen provides a roundup on grouping elections for all passive activities, including non-rental activities.


…7,6,5… Got S corporation basis?

Monday, December 27th, 2010 by Joe Kristan

As we count down tax tips to year-end, we need to address the S corporation basis problem.
As longtime readers know, S corporations are normally not taxed on their income; the income is divided among its owners, who report the income or loss of the corporation on their own tax returns. If the corporation has a loss, the shareholder may be able to deduct it — but only if there is “basis” to do so.
An S corporation can get basis for deducting losses by having basis either in stock of the corporation or in loans made by the shareholder to the corporation. Guarantees of corporation third-party debt don’t count.
Your basis in S corporation stock is the amount you paid for the stock, increased by capital contributions and earnings, and decreased by distributions and losses. Basis in S corporation debt starts with the amount loaned; it is reduced by losses in excess of the basis of corporation stock, and restored by undistributed S corporation income.
With 100% bonus depreciation available for assets purchased after September 8 and placed in service before year-end, many taxpayers find themselves with unexpected tax losses in their S corporations. If they don’t have basis to deduct their losses, they may be in for a nasty surprise on April 15. Any S corporation owner who is counting on deducting losses needs to double-check her tax basis. If basis is short, some thoughts to get those losses:
- Contribute to the capital of the S corporation. This is the easiest way to go, but it can be troublesome if there are other owners who don’t want to be diluted.
- Loan money from personal funds to the S corporation. That can enable you to deduct the losses without diluting other owners. There’s a catch, though: if the loan is repaid before the S corporation has earned back the losses, the repayment will trigger taxable income.
- Borrow money from a third-party and then loan the borrowed funds to the S corporation. These “back-to-back” loans can be effective if you borrow from an unrelated party; they can be disastrous if you borrow from somebody with an interest in the S corporation’s business.
- If you own multiple S corporations, consider combining them in an S corporation holding company. This puts all of your basis in one place, allowing you to use basis from profitable companies to offset losses from others. This is definitely a tool that requires tax pro involvement.
Don’t play basis-around-the-rosey. It’s dangerous borrow from one of your S corporations and loan the funds to another S corporation – especially if the funds end up back in the S corporation where they started. If you have to use funds from one S corporation to get basis in another, take a distribution from the first corporation, rather than a loan, and don’t put the money back where it started.
And remember — it’s not enough to have basis to deduct S corporation losses. The basis has to be “at-risk” and the losses have to be “non-passive.”
We’re counting down to year-end with a new tax tip each day. More tomorrow!


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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Why I think the Tax Court judge got the passive loss 750-hour test wrong

Saturday, August 28th, 2010 by Joe Kristan

Last week I questioned whether a Tax Court judge was correct when he commented that absent an election to combine rental real estate activities under Sec. 469(c)(7), each real estate activity has to meet the “750 hour test” to make a taxpayer a “real estate professional.” This often would make a taxpayer’s status as passive or non-passive hinge on a procedural foot-fault — the filing of the Sec. 469(c)(7) election.
If a taxpayer becomes such a “qualified taxpayer,” then rental real-estate losses can be non-passive, and therefore deductible even absent offsetting “passive” income.
An alert reader poses this question to me:

Re the 750 hour test, Reg.