Originally published on Forbes.com June 13, 2013
If you think you are going to get a hard time from the IRS if you apply for 501(c)(4) status for your new organization called Patriotic Tea Party Support The Constitution And Stomp Out The IRS Inc, try this instead. Report significant losses from real estate rentals and claim you are eligible for the 469(c)(7) exception for people in real estate trades or businesses even though you don’t have a pick-up truck with Joe’s Construction on the side or a brokerage office where a dozen realtors are running around on your behalf. All you are doing is taking care of your own property. It is really hard to make that fly as the recent decision in the case of Peter Hofinga shows.
The Rules
Code Section 469 requires us to put our trade or business activities into buckets. In one of those buckets are the “passive activities”, those where we do not materially participate. There are a number of ways to meet the material participation standard, but 500 hours per year is the gold standard. If the activities in the passive bucket are net negative, the loss is suspended and carried forwarded indefinitely. You get to use the loss in a year in which you have passive income in the bucket or the year in which the associated activity is fully disposed of. A further rule is that rental activities are per se passive regardless of how much you participate in them.
Of course, what would an exception be without an exception to the exception ?
The per se passive rule does not apply if you are in a real estate trade or business. In order to qualify for that you have to spend at least 750 hours in one or more real estate trades or businesses and that has to be more time than you spend doing anything else. So if you are a part time landlord and your day job is being a realtor or owning a construction company (among a few other possibilities), your rental activities will not be passive if you materially participate in them. Since if you have more than a couple of properties it would be hard to spend 500 hours on each of them you are allowed to elect to aggregate them.
You Have To Keep A Log
Can you qualify for the exception just from managing your own properties ? If you have a full time day job, it is close to impossible.
When I read the facts in Mr. Hofinga’s case, I was rooting for him and I thought he had a good shot.
Over the years after they married in 1982, petitioners purchased, and as necessary renovated and remodeled, residential real estate properties that they held for rent. As of the close of 2006, petitioners owned eight rental properties; as of the close of 2007, petitioners owned nine rental properties (collectively, rental properties). Because of an election they made for Federal income tax purposes, petitioners’ interests in the rental properties are treated as one activity.
He owned quite a few properties and he had made the election to aggregate. That is good, but here is what made me extremely optimistic.
Before retiring in 1993 petitioner was employed as a soccer coach and professor of physical education by the University of California Irvine (UCI). He was not employed in any capacity during either year in issue. At all times relevant, Margaret M. Wong (Mrs. Wong) was also employed by UCI.
No day job. All he has to do is hit the 750 hour target.
He still lost and his loss teaches a very important lesson.
Ideally, a taxpayer who claims to be described in section 469(c)(7) would maintain a contemporaneous log or record showing with particularity the amount of time devoted to the rental real estate activity on an event-by-event basis.
The regulations do not require a contemporaneous log, but you would never be able to tell that from looking at the way the case have been going. The Tax Court thought that the reconstructed log that the taxpayer presented was not so bad, but it was not good enough.
Although we expect petitioners, in their role of landlords, expended significant time during each year in issue providing services in connection with the rental properties, we are unable, from what has been submitted, to quantify the total time that petitioner spent doing so, and we cannot ignore the deductions attributable to others’ providing management and maintenance services in connection with the rental properties. Simply put, the logs do not allow for a review of activity related to the rental properties on an event-by-event basis to the extent necessary to establish that the 750-hour test has been satisfied.
IRS Looks At A Lot Of These Returns
Reported Tax Court decisions are the tip of the iceberg in most IRS compliance initiatives. I spoke with my friend Charlie Egerton, a tax attorney in the prestigious Orlando firm, Dean Mead. He has had quite a few of these cases, which mostly settle at appeals. The log is critical. He told me about a revenue agent who is working seventy cases on this issue. Apparently, it is TIGTA that is to blame. TIGTA is the Treasury Inspector General For Tax Administration. They are the folks that gave us the reports about the line dancing Anaheim conference and the Cincinnati gang that couldn’t sort straight picking on the Tea Party. In 2010 TIGTA issued a report to the effect that the IRS was not paying enough attention to real estate losses.
This Will Matter To Even More People In 2013
If your real estate operations were consistently profitable, there was never any reason to worry about whether you qualified for the 469(c)(7) exception. Now there is. Non-passive income as defined under 469 will not be subject to the Net Investment Income tax – the 3.8% Obamacare tax. Even someone who generally would not be subject to the tax because of the AGI threshhold might be in the year that a property is sold. So get working on those logs and make them as specific as possible.
You can follow me on twitter @peterreillycpa.