Posts Tagged ‘real estate professional’

The 3.8% question: Is your rental property a “trade or business?”

Monday, January 28th, 2013 by Joe Kristan
Flickr image courtesy John Snape under Creative Commons license

Flickr image courtesy John Snape under Creative Commons license

The IRS isn’t saying.

It matters for real estate operators. The proposed regulations on the Obamacare “Net Investment Income Tax” impose the 3.8% levy on rental income, but not for “material participants” in a rental “trade or business.” Tax Analysts reports ($link) that IRS attorney David Kirk weasels out of saying what “trade or business” means:

“On one end of the [section 469(c)(7)] spectrum, you have the real estate pro that owns one-tenth of lower Manhattan and lives, breathes, and dies by occupancy, building up, renting out,” Kirk said, adding that that individual would be considered to be in the trade or business of renting real estate.

Kirk declined to say whether someone on the other end of the spectrum — the real estate broker who not only lists houses but also owns a couple of townhouses or condos — would be considered to be in the trade or business of renting real estate. “I’m not really comfortable coming out and saying what a trade or business is,” he said.

The term “trade or business” has been defined some under Section 108(a)(1)(D), which allows taxpayers to exclude debt cancellation income if the debt was on “trade or business” real property. The IRS discussed the issue in PLR 9840026 (some citations omitted):

The rental of even a single property may constitute a trade or business under various provisions of the Code. However, the ownership and rental of property does not always constitute a trade or business. The issue of whether the rental of property is a trade or business of a taxpayer is ultimately one of fact in which the scope of a taxpayer’s activities, either personally or through agents, in connection with the property, are so extensive as to rise to the stature of a trade or business. Bauer v. United States, 168 F. Supp. 539, 541 (Ct. Cl. 1958); Schwarcz v. Commissioner, 24 T.C. 733 (1955); See Higgins v. Commissioner, 312 U.S. 212 (1941) (management of taxpayer’s own investment portfolio not a business).

In Rev. Rul. 73-522, 1973-2 C.B. 226, the Service held that rental of real property under a “net lease” does not render the lessor engaged in a trade or business with respect to such property for purposes of section 871 of the Code

It was unwise to make “trade or business” status key to this tax; it makes it difficult for taxpayers to know whether it applies and it encourages taxpayers to be agressive. They should just say that if you achieve non-passive treatment as a real estate professional, you don’t pay the tax.

Related: Real Estate Professional Status – Becoming More Important – Very Hard To Prove (Peter Reilly)

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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

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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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How many ways can’t you deduct your vacation cabin?

Thursday, April 22nd, 2010 by Joe Kristan

Once you decide to buy that vacation cabin, you’re committed. If you vacation anywhere else, you feel like you’re squandering your investment. Yet you can’t spend all of your time there, and it would sure be nice if you could get some tenants while you’re not there. It’s even nicer if the IRS can help you pay for it.
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Flickr image courtesy Let Ideas Compete under Creative Commons license
And yes, there are tax breaks for second homes. The biggest one is the home mortgage interest deduction, available for up to two homes. You can also deduct property taxes, at least if you aren’t subject to alternative minimum taxes. But what about the home itself, and your out-of-pocket costs? Can you claim the cabin as a rental property, deduct depreciation, insurance, and maintenance, and move your property taxes to an “above-the-line” schedule E deduction?
Probably not. It didn’t work for a California man with a 3-bedroom cabin. The man deducted $20,258 as Schedule E losses in 2004. The Tax Court sets the stage:

Petitioner contracted with Alpine Resort Rentals (Alpine), a property management company, to rent the cabin for the 2004 tax year. Per the rental agreement, Alpine had an exclusive right to rent the cabin during 2004. For its services, petitioner paid Alpine a 35 percent commission of all rental income received. Among other things, Alpine was responsible for arranging housekeeping and linens for rental customers; petitioner was responsible for maintaining the property in a safe and aesthetic condition, paying all utilities, having the property “deep cleaned” twice a year, and providing linens.
The cabin was rented 3 times during the 2004 tax year, for a total rental period of 12 days and 9 nights. The parties have agreed that the average rental period of customer use for the cabin for 2004 tax year was 3 days.
Petitioner visited the cabin eight times during 2004, for a total of approximately 27 days and 19 nights. Each time petitioner visited the cabin during 2004, he was accompanied by family members.

The IRS attacked the loss on two fronts. First it went after the loss under the “passive loss” rules. Normal rental real estate losses are subject to a “per-se” passive loss limit, unless you are a real estate professional. Our Californian tried to take advantage of a special rule that allows taxpayers with adjusted gross income under $150,000 to deduct rental real estate losses when they “actively participate” in the rental activity. The IRS countered:

An activity involving the use of tangible property, however, is not considered a rental activity for a taxable year if for such taxable year the average period of customer use for such property is 7 days or less. Sec. 1.469-1T(e)(3)(i) and (ii)(A), Temporary Income Tax Regs., supra. Therefore, owners of rental real estate are not considered to be engaged in a rental activity if the average period of customer use is 7 days or less.

Failing that, the taxpayer argued that if it wasn’t a “per-se” passive activity, he wasn’t “passive” and could deduct the losses under one of two rules: either he did “substatially all” of the work involved in the property, or he spent at least 100 hours and more than anyone else. The Tax Court said this failed too (my emphasis):

To satisfy one of these tests, petitioner must establish that either (1) no other individual’s participation exceeded petitioner’s participation during 2004 or (2) that petitioner participated in the activity for more than 100 hours in 2004. With regard to the second requirement, petitioner has set forth little evidence to establish that he was involved in the rental of the cabin for more than 100 hours in the 2004 tax year. He has alleged that he took eight maintenance trips to the cabin during 2004, but in no way has he quantified for the Court the amount of his active participation time. In order to establish that he did spend more than 100 hours engaged in the rental of the cabin, the Court would expect petitioner to provide evidence corroborating his claim that his trips to the cabin were indeed for the purpose of maintenance, e.g., in the form of time logs, oral testimony, and/or receipts.
Nor has petitioner established that no other individual’s participation exceeded his participation in the activity or that his participation constituted substantially all the participation in the activity. Alpine was responsible for advertising, showing, and renting the property, and after each tenant, a cleaning service cleaned the property. Further, petitioner has conceded that his daughter assisted in the management and maintenance of the cabin and that he contracted with professionals to provide repair services during 2004. While we do not know how much time these services took, they involve a substantial amount of time.

It’s up to you to prove your participation, and the Court found the taxpayer failed to do so.
The other IRS line of attack on vacation home deductions is Sec. 280A, which limits operating deductions for vacation homes to rental income if the cabin is used personally for the greater of 14 days or 10 percent of the day is is rented. Maintenance trips don’t count as personal use, but again it is up to the taxpayer to prove that a trip is a maintenance trip:

Petitioner has presented no evidence to substantiate his contention. He has not provided to the Court any receipts, work reports, time logs, or testimony to support his claim that the motive of his trips and his activity at the cabin was in fact for upkeep. Although cautioned at trial that his opening statement was not evidence that the Court could rely on to make findings of fact, petitioner chose not to testify at the trial, relying entirely on the stipulation of facts and the stipulated exhibits to provide all of the evidence in his case. Hence, petitioner has failed to meet his burden of proving that personal use of the cabin did not exceed the greater of 14 days. Consequently, the cabin is considered a residence for purposes of section 280A.

The taxpayer didn’t lose all of his tax breaks. Because he rented the house for less than 15 days in 2004, he was allowed to exclude the rent received from taxable income. He also was allowed itemized deductions for his mortgage interest and property taxes. But the rest of the deductions — depreciation, repairs and so on — were lost.
The Moral? If you want to take deductions for your vacation home above the line, you need to keep records of how much time you spend there, and how you spend it. If you can’t prove your participation, the tax law won’t help you.
Cite: Akers, T.C. Memo 2010-85
Related: NON-PASSIVE RENTAL LOSSES: NO FUN WITH DICK AND JANE

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Passive activity: not just an oxymoron; it’s the law!

Thursday, January 7th, 2010 by Joe Kristan

Only 23 years after the “passive activity” rules became law, the IRS has decided how taxpayers should report changes in how they “group” their “activities” (Rev. Proc. 2010-13).
The 1986 Tax Act set up the passive activity rules to shut down that era’s breed of tax shelters. Losses from activities in which a taxpayer is “passive” are deferred to the extent they exceed “passive” income until the “activity,” whatever that means, is disposed of.
The tax law says activites other than rental activities are generally passive or non-passive based on how much time a taxpayer spends on the activity — the “material participation” rules. For example, if a taxpayer spends 500 hours working in an activity in a year, it is non-passive. Also, if a taxpayer has multiple activities with 100-500 hours of involvement, and they add up to more than 500 hourse, they are non-passive. Rental activities are normally passive, exept for certain full-time real-estate professionals. A more complete summary of the “material rules is below the fold.
So what is an “activity?” It matters because if you have a lot of activities, you will have a hard time getting to 100 or 500 hours for any of them; but If you have only one activity, and it’s passive, you have to sell the whole thing to take your accumulated passive losses.
Until now, the IRS hasn’t really required taxpayers to disclose how they “group” their activities. The tax law provides for a specific election — the Sec. 467(c)(7) election — for real estate professionals to “group” their real estate activities — but otherwise groupings aren’t explicitly reported.
The new revenue procedure doesn’t require an annual schedule to report all of a taxpayer’s groupings, but it does require taxpayers to report changes in groupings, starting with 2011 returns. It appears that the IRS is worried about people combining too many groups:

…if a taxpayer is engaged in two or more trade or business activities or rental activities and fails to report whether the activities have been grouped as a single activity in accordance with this revenue procedure, then each trade or business activity or rental activity will be treated as a separate activity for purposes of applying the passive activity loss and credit limitation rules of section 469. Notwithstanding the previous sentence, a timely disclosure shall be deemed made by a taxpayer who has filed all affected income tax returns consistent with the claimed grouping of activities and makes the required disclosure on the income tax return for the year in which the failure to disclose is first discovered by the taxpayer. If the failure to disclose is first discovered by the Service, however, the taxpayer must also have reasonable cause for not making the disclosures required by this revenue procedure.

Taxpayers should use this new Revenue Procedure as a reminder to think about their activities. Many entrepreneurs have a lot going on. They might have one 500-hour activity and several others. Can all activities reasonably be grouped together? If not, should the sub-500 hour activities be grouped to make sure they all get to 500 hours together? Should any of the sub-500 hor activities be combined to get them over the 100-hour threshold? Has the nature of any activities changed in a way that means the groupings should be changed? And do you have a way to prove your participation to an IRS agent? Keep a calendar to make sure.
Related: Real-estate agent wins passive loss argument in Tax Court

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Don’t want to be passive? Track your time.

Tuesday, December 1st, 2009 by Joe Kristan

The passive loss rules restrict losses from most businesses unless a taxpayer “materially participates.” Rental real estate losses are always passive unless the taxpayer is a “real estate professional,” who spends at least 750 hours, and more than half of his or her working hours, working in real estate.
A couple with Massachussetts real estate learned the hard way that the courts won’t take your word for how much time you work on your real estate:

Mr. Kibiro testified that he and his wife did not keep “meticulous records” regarding the rental properties, and petitioners produced no such records at trial. Although Mrs. Njoroge testified that she traveled to the Springfield property two or three times a week, there is no indication of the number of hours she spent working on the rental properties. Consequently, petitioners have not established that they meet the requirements of either section 469(c)(7)(B)(i) or (ii). Because petitioners have failed to establish that either spouse qualifies as a real estate professional under section 469(C)(7)(B), their rental real estate activity is per se passive under section 469(c)(2)

If it’s not your full-time job, you really need to track your time on your business. Keep a daily calendar of your time, and don’t put it together the day the IRS agent comes to audit you.
Cite: Njoroge, T.C. Summ. Op. 2009-177
Related: Real-estate agent wins passive loss argument in Tax Court

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Real-estate agent wins passive loss argument in Tax Court

Tuesday, March 3rd, 2009 by Joe Kristan

One of the hidden advantages of being in the real-estate business is the ability it provides to deduct otherwise “passive” rental losses. If you are a “real estate professional” under Code Sec. 469(c)(7), rental real-estate losses aren’t “per-se” passive, like they are for other taxpayers; instead, you determine whether your real estate losses are “passive” using the same “material participation” tests that apply to all other business activities. A “real estate professional” has to spend 750 hours or more a year in a “real property trade or business” and cannot work more hours in non-real estate businesses than in real estate.
Sudha Agarwal was a full-time real-estate agent at a Century 21 brokerage in California. She also owned two rental properties with her husband. Together Mr. and Mrs. Agarwal performed all of the work on the properties, meeting one of the tax law’s tests for material participation. She therefore claimed the losses as non-passive, and deductible, based on her status as a “real estate professional.”
The IRS disagreed, making the arguing that Mrs. Agarwal wasn’t a “real estate professional” under the tax law. The tax law defines “real property trade or business” (my emphasis):

any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

The IRS made the novel argument that a real estate “agent” isn’t in the “brokerage” business. The Tax Court explored the meaning of “brokerage” in Sec. 469(c)(7) and concluded that it meant what every normal person would conclude: that real estate agents are in the “brokerage” business.
Cite: Agarwal, T.C. Summary Opinion 2009-29.
Read more for an overview of the tax law rules for “material participation.”

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PASSIVE LOSSES: MARK YOUR CALENDAR (CAREFULLY)

Wednesday, November 14th, 2007 by Joe Kristan

20071114-1.jpgA Tax Court case issued yesterday illustrates how hard it can be to get around the anti-taxpayer tilt of the “passive loss rules.” These rules were enacted in 1986 to shut down the retail tax shelter industry by limiting your ability to deduct losses from businesses you don’t actually work for.
Limits on real estate losses are key to the passive loss rules. For most taxpayers, any losses from real estate are automatically “passive,” so you can’t use real estate rental losses to offset your salary or interest income. There are two important exceptions to this rule:
- If you “actively” participate in a rental activity, you can deduct up to $25,000 of real estate losses; your ability to deduct these losses begins to phase out when adjusted gross income reaches $100,000, and disappears completely at $150,000 AGI.
- If you are a “real estate professional,” you can deduct rental real estate losses if you “materially participate” in the real estate activity. To be a real estate professional, you have to spend 750 or more hours annually in the real estate business, and you have to spend more time in real estate than in any other business activity (a more complete discription of “material participation” is at the bottom of this post).
The $186,487 part-time job
Carolyn Fenderson worked for Symantec, the software company, in 2002. The Tax Court describes her job:

In 2002 petitioner’s compensation from Symantec totaled $186,487. Some of the commissions included in that amount relate to sales of software licenses made in years prior to 2002. According to petitioner, she spent about 15 hours a week working for Symantec during 2002. She maintained a calendar that tracked her activities and appointments in connection with her employment at Symantec, which ended during 2003.

Ms. Fenderson, by her own account, was busy in 2002, operating 10 residential real estate properties. She claimed “real estate professional” status and said she was eligible to deduct the loss.
The Tax Court’s evaluation of her argument illustrates how the courts look at the evidence of participation in an activity under the passive loss rules. Ms. Fenderson had to demonstrate that she spent at least 750 hours working on her properties and that she spent more time on them than she did for her regular job. She had no detailed time records for either job. The Court had no evidence as to the time spent on her Symantec job, so they assumed “without finding” that she was correct in saying she worked 15 hours a week there; since 15 hours x 52 weeks is 780, she would need at least that many real estate hours to qualify as a real estate pro.
To document her real estate time, Ms. Fenderson worked up a summary of hours based on her appointment calendar. The tax court found her summary wanting:

A number of inconsistencies between items shown on petitioner’s 2002 return, her calendar, and the exhibits were brought out during petitioner’s cross-examination at trial. Furthermore, upon careful review of those documents, we are unable to reconcile estimates of time shown on Exhibits 3-J and 4-P with entries made in petitioner’s calendar. On many dates, the estimate of time spent on a particular activity exceeds the amount of time shown on that calendar for that date.

The court adjusted down her time based on the inconsistencies they found in the calendar, and decided she could only document 759 real estate hours – 21 hours less than her Symantec time.
The Moral? If you say you have a $180,000 part-time job, the tax law is likely to look pretty hard at your claims that you work more than that on your side job.
Cite: Fenderson v. Commissioner; T.C. Summ. Op. 2007-191
MATERIAL PARTICIPATION BASICS

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