Originally published on Forbes.com July 24th, 2013
Real estate pro status is becoming the impossible dream of taxpayers throughout the nation. The Tax Court decision in the case of Jesse and Patricia Bugarin is a real frustrating example, because I can’t help but think that if I were in their corner and they listened to me they would have won.
The Rules
The Tax Reform Act of 1986 tried to drive a stake through the heart of the tax shelter vampire by requiring us to group our trade or business activities into buckets based on whether we “materially particpate” in them. Those activities in which we do not materially particpate go into the oxymoronic “passive activity” bucket. Losses from passive acitivities are suspended unless there is income from other passive activities or the particular activity is disposed of.
Another rule is that “rental activities” are per-se passive even if you do materially participate in them. In the 90’s an exception to the per-se rule was carved out for people who spend most of their time in real property trades or businesses that they have an ownership stake in.
What Happens In Real Life
Most of the case law in this area seems to be generated by people claiming the exception to the per-se rule even though their only real estate activity involves property that they own themselves. The have to meet two hurdles. One is to have more than 750 hours and the other is to spend more time on real estate than anything else they do to make money. The latter hurdle dooms most. If you have a full-time day job, it appears that the IRS will just not believe that your regular job does not absorb more than half your working time. The Tax Court almost always backs them up.
The other problem is that you have to prove how you spend your time. Although the regulations are vague on the subject, the demand seems to be for detailed contemporaneous logs with supporting documentation (such as phone bills, invoices and e-mail print-outs). Never, ever use the word “ballpark” as in “balpark guestimate”. Here is something else I have inferred from reading too many decisions of this issue. When a Tax Court judge says “purportedly”, what he really means is “Liar, liar. Pants of fire.”
Some Pretty Good Facts
Mr. and Mrs. Bugarin owned three rental houses and spent time prospecting for more. Mrs. Bugarin was the one taking care of the property. She was also taking care of two kids, one of them only four, but you can still see it being reasonable that she would make the 750 hour hurdle. More improtantly, she had no paid employment, so all she needed for the exception was 750 hours. It kind of went downhill from there.
The Logs
At trial petitioners provided a log to the Court to account for the time spent on the rental real estate activities. When respondent’s counsel asked petitioner “when” the log was created, she responded that she created the log of her rental real estate activities using her cell phone and “Outlook” software.
The log was not contemporaneous.
Petitioners submitted a three-ring binder with 12 dividers containing copies of substantially similar printed sheets purporting to document petitioner’s real estate activities monthly for 2009. Each of the sheets bears a date and states a certain number of hours, and many of the sheets reference one of the three properties at issue. Petitioners offered no evidence that the sheets were prepared contemporaneously with the events they describe. Some of the sheets describe an activity without ascribing it to a particular property, and some of the sheets mention a particular property without describing any activity. Some of the sheets attribute an activity to a particular property without explaining how the activity relates to the property. Some of the entries appear to exaggerate the amount of time spent for a particular task, such as recording 20 hours for painting a bathroom in one of the houses.
The log does not contain enough detail, a sure sign that it is just “purporting”, and we know what that means.
It Gets Worse
This is something that a lot of people trip up on, because these rules are so confusing. The real estate pro status just gets you out of the “per-se” rule. You still have to show that you “materially participated” in each of your properties. The gold standard of material participation is 500 hours, which, of course, is impossible if you have several properties. You are, however, allowed to elect to aggregate your properties into a single activity for purposes of measuring participation. The Bugarins failed to make the election.
Petitioner’s binder purports to record a total of about 810 hours devoted to her real estate activities in 2009. She testified that she spent “a good 50 percent” of her time “out and about looking” or on the phone or the computer looking for additional homes to purchase. The Court analyzed the binder sheets and found entries suggesting that over 200 hours were dedicated to “prospecting”, looking, searching, viewing, or meeting for or about potential home purchases and associated activities.
You can also meet material partipation by doing more than anybody else even if you have less than 500 hours. That did not work for Mrs. Bugarin.
The Court examined the hours listed on the sheets for activity ascribed to property A and determined that the total was 45 hours. Petitioner could qualify as materially participating in the property A activity only under criterion (2). Accepting at face value the hours and activities listed specifically for property A, the Court determined that at least 20 of the hours spent on this property, 44% of the total, involved the participation of other individuals who were not owners of the property. Therefore, petitioner’s participation in the property A activity for the taxable year did not constitute substantially all of the participation in that activity of all individuals during the taxable year and so petitioner did not materially participate in the activity in 2009.
The problem is that much of the time that counted toward the 750 hours to meet the exception did not count towards material participation in the existing properties.
The Court did not count general listings for items like banking, meetings, or visiting stores that did not reference a particular property as it was not apparent that they represented services in petitioner’s rental real estate activities or to which of the three rental properties they might relate if they were such services. The Court also excluded petitioner’s activities in pursuit of acquiring ownership in new properties because they were not related to the operation of petitioner’s respective rental activities related to the three rental properties petitioners already owned in 2009. Petitioner’s “prospecting” activity cannot be connected to any one of the three rental properties and therefore cannot be included as material participation in their respective operations.
Given the exclusion of “prospecting time”, even the election might not have saved them.
Accepting at face value all of the hours and activities listed that were ascribed specifically to either property B or property C, the Court determined that petitioner devoted 228.5 hours to property B and 178 hours to property C. In addition, petitioner listed one hour each month for “accounting” for the properties. Assuming material participation in the two above rental property activities in 2009, petitioner performed only 418.5 hours of services in real property rental activities in which she materially participated.
Rubbing Salt In The Wound
If the tax understatement crosses a numerical threshold, you can count on the IRS going for the 20% penalty, but the Tax Court frequently cuts the taxpayer a break. Not this time:
Petitioners claimed $27,456 of itemized deductions for which they offered at trial no substantiation or explanation. Their log of real estate activities failed to justify their claimed rental real estate deductions. Petitioners did not show that there was reasonable cause for, and that they acted in good faith with respect to, the underpayment of tax for 2009.
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