Originally published on Forbes.com.
The IRS bit off more than it could chew when it tried to claim that Roy Stanley did not qualify for real estate trade or business relief from the passive activity loss rules. The decision in his case has not attracted much attention, but advisers to major real estate players would be well advised to study it. Even Donald Trump’s guys should take a good look at it.
Stolen Real Estate Chutzpah
You will read from time to time about the phenomenon of “Stolen Valor” – people who greatly exaggerate or entirely fabricate their military experience. In tax practice, there is a similar concept – people who claim that they are real estate professionals. Samuel Johnson remarked that “Every man thinks meanly of himself for not having been a soldier, or not having been at sea”, which largely accounts for the stolen valor thing. The real estate professional thing originates in a special rule that relaxes the general prohibition on rental losses sheltering other income. Although frankly, there is probably a little ego buzz going on there too.
Sorting Out The Real Estate Pro Wannabees
Every once in a while, someone will think that they are exposing a phony veteran and it will turn out that they are the ones who are wrong. It happened recently in a Charlotte airport. Of course it is the IRS that challenges the real estate pro credentials. The typical case is somebody employed full time, say as an engineer, who owns a couple of rental properties. To qualify as a real estate pro, they have to spend 750 hours in a real estate trade or business and, the really hard part, more time on the real estate than on the day job.
How Did We Get Here?
I tend to not spend a lot of time reflecting on why the tax law is the way it is. Reilly’s First Law of Tax Planning – It is what it is. Deal with it. Code Section 469 is a particular interest of mine. It is why I named this blog Passive Activities – a shortened version of my now archived Passive Activities and Other Oxymorons, which had a readership numbering in the scores. The passive activity rules were introduced by the Tax Reform Act of 1986. The committee report has a lengthy explanation, but perhaps it is summed up with this extract
…the committee believes that decisive action is needed to curb the expansion of tax sheltering and to restore to the tax system the degree of equity that is a necessary precondition to a beneficial and widely desired reduction in rates
Back in the day, the day being before 1986, a building that could produce enough net operating income to cover its debt service had an additional value as an inherent tax shelter. So if you were going to, for example, rehabilitate some affordable housing in Boston you might need a community development corporation, HUD rent subsidies, site control, MHFA financing, a construction company, a project manager and fifteen dentists, inclined to shelter their income. Oh yeah and a CPA, who could figure this out – Reilly’s Third Law of Tax Practice – Any reasonably complex tax matter involving significant dollars, regardless of whatever else it might be, is a white collar jobs program.
So Code Section 469 forces you to divide your trade or business activities between those that you don’t materially participate in and those that you do. Losses from the passive activities are suspended and can only be used against passive income or when the activties are entirely disposed of. The icing on the cake was that real estate rental activities were deemed to be per se passive.
The extensive use of rental activities for tax shelter purposes under present law, combined with the reduced level of personal involvement necessary to conduct such activities, make clear that the effectiveness of the basic passive loss provision could be seriously compromised if material participation were sufficient to avoid the limitations in the case of rental activities.
Clearly when they put these rules in effect they were thinking more about my dentists, than somebody like Roy Stanley
Roy Stanley
Roy had practiced law in Arkansas from 1978 to 1994, when he began working full time as President of Lindsey Management Company, which is a pretty substantial organization managing over 38,000 apartments and 42 golf course. By 2009 Roy was working half-time for LMC while also serving as its general counsel. He also served as the President of Lindsey Communications Inc which provided telecommunications services to some of the manage properties, but that’s not all.
Throughout his employment with LMC, Roy had acquired minority interests in the entities that owned and operated the rental properties and adjacent golf courses managed by LMC. The Stanleys had ownership interests in more than 100 entities, directly owned two rental properties and had interests in 90 other entities through the Roy E. Stanley Family Limited Partnership.
It seems like Roy Stanley was exactly the type of person they had in mind when Code Section 469 was amended in 1993 to add a special rule for “taxpayers in real property business” (We all speak in terms of real estate professionals, but the professional term is not in the statute). It relaxed the per-se passive rule for them. It also allowed them to aggregate all their real estate activities, since it would be really challenging to meet any of the material participation standards for each of 100 properties.
The IRS went after him anyway trying to treat him like the countless full-time employees who have tried to convince the Tax Court that they are really spending most of their time on real estate and not their unrelated day job. (They are not really countless, just more than I care to count. It’s an expression.)
You Have To Be An Owner
The main way they went after Roy Stanley was on the requirement that the real property services don’t count if you are performing them as an employee. In typical Internal Revenue Code fashion there is an exception for employees who own at least 5% of the company. So if we start out with the notion that Roy had losses from some of the flow through entities that he could deduct except for Code Section 469, then the 5% rule is an exception to an exception to an exception.
Roy’s 10% ownership of the stock in LMC was well documented, but the government sought to argue that the agreement that required him to turn the stock in on the termination of his employment meant that he was not a “real owner”. It was a very complicated argument, but the court disposed of it rather handily.
The Court further finds that it is immaterial to this case whether LMC should be treated as a corporation or a partnership for purposes of 26 U.S.C. § 416(i)(1)(B)(i). If LMC is treated as a corporation, the Court finds that Roy has shown he owned 10 percent of the “outstanding stock.” The Court has already set out the evidence of record substantiating Roy’s ownership of the stock, and the Court does not find that the word “outstanding” imposes some additional requirement that the stock be readily transferable or not at risk of forfeiture that would operate to prevent Roy from claiming ownership for purposes of 26 U.S.C. § 469(c)(7)(D)(ii). Rather, Roy owned 10 shares of 100 shares of stock issued by LMC. Therefore, in the ordinary understanding of the term, Roy owned 10 percent of outstanding LMC stock. Furthermore, Roy argues that his interest in the stock (an interest that was subject to being surrendered upon the occurrence of certain events, such as Roy leaving LMC’s employment) would have been transferable, and the Government has not persuaded the Court that Roy’s argument is incorrect. If, alternatively, LMC should be treated as a partnership for purposes of 26 U.S.C. § 416(i)(1)(B)(I), the Court finds that Roy has substantiated that he “own more than 5 percent of the capital or profits interest in the employer” as required. In either event, the Court finds that Roy was a ten-percent owner of LMC for purposes of 26 U.S.C. § 469(c)(7)(D)(ii).
They Also Serve
The IRS took another angle of attack, which was a really interesting one. Allowing that LMC was a real estate business and that Roy owned 10%, there is the issue of exactly what he was doing. According to the IRS any legal work he did should not count towards the 750 hours. The court was not having any of that:
Section 469 does not, however, require that the services performed in a real property trade or business be of any specific character or that all such services must be directly related to real estate. Rather, the services must simply be performed “in real property trades or business in which the taxpayer materially participates.”
It reminds me a bit of the veterans I used to hang out with who sometimes could have exacting standards of what constituted a real veteran. The court’s standard is very liberal looking at just what the company is doing.
The other issue was whether time spent working for LMC would count towards material participation in the grouped real estate ownership activity with respect to properties managed by LMC. The court had no problem with that. They also dismissed the government argument that time spent managing property should be discounted based on Roy’s ownership interest in the property.
The Forum
The stakes were pretty high in this case, just over $130,000. Rather than risk Tax Court the Stanleys went the route of paying the tax and suing for refund. It may well have been calculation of the odds, since taxpayers have not done that well in Tax Court in 469 cases, although usually their facts are a lot worse. That this is a district court decision lessens its value as precedent. Adam Chodorow told me that the Tax Court judges consider themselves the experts. They are bound to follow appellate decisions, but only in the circuits where they are decided.
Higher Stakes In The Future
The IRS’s extremely aggressive posture in this case might be a sign of things to come. Up until last year all these messy complicated rules only mattered if you had losses. Now material participation in a trade or business activity will also exempt you from the net investment income tax. Thus operators like Roy Stanley might be seeking real estate professional status even when all their properties are consistently profitable.
Other Coverage
Arkansas Business did a story on the case when it was first filed, but it is behind a pay wall and I’m sort of a cheapskate.
Back in 2005 thecabin.net published a letter from Roy Stanley in which he defended the honor of developers against the mainstream media which too often echoes environmental extremists, at least in his view.
So the next time you hear someone railing against real estate developers in general or the Lindsey Companies in particular, remind them of the ways in which we perform a vital function in our economy and make an irreplaceable contribution to the American way of life. And unless they live in a tent or sleep on a park bench, chances are that a real estate developer is responsible for putting a roof over their heads.
Parker Tax Publishing has a piece titled – Court Rejects IRS Arguments Aimed At Limiting Taxpayer’s Real Estate Losses.
The case is useful as a roadmap for taxpayers with multiple rental properties and businesses as to what the IRS may attempt to argue to prevent taxpayers from taking losses against non-passive income and how taxpayers can rebut those arguments.
Ed Zollars in Restricted Stock Interest Still Found To Constitute Ownership Interest for Qualifying as Real Estate Professional concluded.
The case is interesting because of the nature of the matters considered, especially the impact of restricted Section 83 stock held by an S shareholder in a real estate business. But advisers should note this represents a single U.S. District Court case and it’s very possible that a different court (especially one that hears many more tax cases) might not react as favorably to the same arguments.