People have a lot of trouble meeting the real estate trade or business exception to the rule that makes real estate rental per se passive. Usually the problem is that they have substantial day jobs. If you are working as a lawyer or an engineer or something like that, your annual threshold for meeting the exception is the greater of 750 hours or the amount of time you spend on your day job. Even if you really do spend more time on your properties, you still have to meet the challenge of proving it.
It seems like the exception was meant for people like Gary Hoskins. He worked full time selling property and managing property for banks. He made the election to aggregate his rental properties, something that trips up quite a few real estate pro wanabees. He still lost in a recent Tax Court decision. Here is some of the story:
During the years in issue petitioner maintained his Florida real estate sales license under a brokerage, Prudential Palms Realty, and worked approximately 40 hours per week as an independent contractor assisting other individuals with selling, purchasing, and leasing homes. In addition, as a licensed real estate salesperson, petitioner provided maintenance services for bank-owned properties approximately 15 to 20 hours per week.
The Tax Court ended up not opining on whether those two activities qualified him as being in a real estate trade or business, since he lost for another reason, but let’s assume that it was good enough. How could he end up losing anyway ?
During 2006 and 2007 petitioners owned four properties in Ohio (Glenrose, Hialeah, Martindale, and President) and six properties in Florida (Bentgrass, Founder, Mellon, Midnight #1, Midnight #2, and Trenton). In 2006 the four Ohio properties and three of the Florida properties (Bentgrass, Mellon, and Midnight #2) were rented long term. In 2006 the Midnight #1 property was rented as a short-term vacation rental for periods that, on average, did not exceed seven days.
In 2007 two of the Ohio properties were rented long term (Glenrose and President); the Hialeah and Martindale properties were not rented because they were being prepared for sale. Three of the Florida properties were rented long term in 2007 (Bentgrass, Mellon, and Trenton), and two of the Florida properties were rented as short-term vacation rentals for periods that, on average, did not exceed seven days (Midnight #1 and Midnight #2). The Founder property was not rented in 2007 because it remained under construction through the end of that year.
The IRS examined petitioners’ 2006 and 2007 tax returns. During the examination petitioner stated that he spent approximately 520 hours during 2006 and 520 hours during 2007 working on petitioners’ properties, performing such activities as painting, lawn mowing, and cleaning the properties to prepare them for renting. Petitioner did not provide any log or other documentation to support his statements, nor did he offer any records detailing repairs or maintenance performed by him or by other individuals.
The Tax Court has its usual complaint about their not being good enough proof of how he spent his time:
Petitioner’s testimony concerning his participation consisted only of estimates based on recollections of events that had taken place several years before. Petitioner’s subjective time estimates suffer from a lack of contemporaneous verification by records or other estimates.
That ended up not being his only problem. 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.
For petitioners’ grouped properties that are considered rental real estate activity, petitioner claimed that he spent 331 hours in 2006 and 212 in 2007 participating in the rental real estate activity, but admitted that he kept no records, such as calendars or logs, detailing his time and activities.
That was short of the 500 hour threshold that is the gold standard of material participation.
More At Stake In 2013
Mr. Hoskins had quite a bit at stake in this case. He ended up having over $400,000 in losses deferred. He will likely get those losses someday either when he has positive income from rental real estate, perhaps when he sells a property, or totally disposes of an interest (The election which did not help him when he thought it would may harm him there, but that is another story.) Still, this issue has only applied to people like Mr. Hoskins who want to deduct current losses. Starting in 2013, the issue will also apply to people who are consistently profitable. Real estate rental income and, perhaps more significantly, gain on the sale of such properties will be subject to the 3.8% Obamacare tax, unless you meet the real estate trade or business exception. The supply of these cases promises to be endless.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Feb 13th, 2013