Originally published on Forbes.com Nov 11th, 2014
If you are involved in construction and reconstruction, you may get a better deal on your losses from rental real estate and beginning with 2013 avoid the Obamacare tax on gains from rental real estate. But what exactly is construction and reconstruction? The Tax Court had to look it up in the dicitionary. Here’s the story.
Some Background
The stake in the heart of the tax shelter vampire provided by the Tax Reform Act of 1986 was Code Section 469, which introduced the oxymoronic concept – passive activities. Other sections of the Code, like those concerning S corporations discuss “passive income” – interest and dividends and the like, but such investment income is not the passive activity income that 469 refers to. Passive activity income and more significantly loss comes from a trade or business activity in which you do not materially participate. We are required to divide our trade or business income from proprietorships, partnerships and S Corporations into two buckets. If the passive bucket is a net loss, the loss is suspended and carried forward to be used if there is passive income in the future or when the underlying activity is entirely disposed.
The rules about how you classify your activities and measure material participation are mind boggling in their complexity. Don’t get me started. There is one rule that created a lot of angst, though. Rental activities are per se passive. This was troubling to people in the real estate industry who might for example have rental losses on a development while making money on the sale of property. So a special rule was created for people involved in real estate trades or businesses. If you spend more than 750 hours per year in real estate trades or businesses and the amount of time that you spend in the real estate trades is greater than the amount of time you spending doing anything else, then the per se passive rental income rule does not apply to you. Rental losses are not passive, if you materially participate in the related properties.
Not Easy For People With Day Jobs To Be Considered Real Estate Pros
For some reason, the IRS is particularly zealous in enforcing Code Section 469. If you have substantial income and are posting losses from rental activities, you can put as many “I love Obama” signs on your lawn as you want and you still have a better than average chance of being challenged. At least that is my inference from the cases I read and some discussions with other practitioners.
The way the cases have broken, people with non-real estate day jobs who claim that they spend more time on their amateur landlord activity are almost always accused of having insufficient records of their time, “ballpark guestimates, a colorful term that the Tax Court seems to have reserved for 469 cases. Even in the cases where people have logs, they are often found to be improbable. You don’t see “pants on fire” in the decisions, but you suspect the judges are whispering it under their breath.
Construction And Reconstruction
Howard Cantor’s recent trip to Tax Court introduces a seldom explored angle. What exactly qualifies as a “real property trade or business”? The legislative and regulatory guidance is a little sketchy.
A real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Sec. 469(c)(7)(C). The determination of whether a taxpayer’s activities constitute a real property trade or business “is based on all of the relevant facts and circumstances.”
Mr. Cantor was involved in the ownership of four rental properties. The IRS conceded that he materially participated in the operation and management of the properties. He had a pretty demanding day job, though. He spent 40 to 50 hours a week running his proprietorship called ABS Glass. The NAICS code on his Schedule C was 811120, which stands for “Automotive, Paint, Interior, and Glass Repair”. The NAICS classification of business is a return question that, in my experience, seldom merits much deep thought. Actually it tends to get copied over from one year to the next. That may have been what happened on Mr. Cantor’s return, because there is a wrinkle to his business that he thought would allow his rental losses.
ABS Glass started out doing automotive glass replacement, but then it expanded its services. There was residential division.
Obviously, the services performed by petitioner in connection with the automotive division of ABS Glass are not services petitioner performed in a real property trade or business. According to petitioners, the services petitioners provided in connection with the residential division of ABS Glass are “construction” or “reconstruction” activities that qualify the residential division of ABS Glass as a real property trade or business under section 469(c)(7)(C) for both years in issue. As petitioners view the matter, the time petitioner spent performing services in connection with the residential division of ABS Glass qualifies him as a real estate professional as described in section 469(c)(7)(B).
Mr. Cantor argued that all the time he spent on residential glass work qualified as construction or reconstruction. The Tax Court was not so sure.
Webster’s II New Riverside University Dictionary (1984) defines the term “construction” as “he act or process of constructing” and defines the term “constructing” as “o put together by assembling parts”. Webster’s II New Riverside University Dictionary 983 defines the term “reconstruction” as “he act or result of reconstructing” and defines the term “reconstructing” as “o construct again.” Nothing in the dictionary definitions limits the terms to real property construction or reconstruction, but the statute expressly imposes such a limitation.
Keeping that limitation in mind, we assume without finding that installing original or replacement windows in newly built or existing buildings constitutes “construction” or “reconstruction” within the meaning of section 469(c)(7). On the other hand, we find that cutting and installing mirrors and table tops, cutting and installing shower and bath glass enclosures, and replacing window panes do not.
No Logs
It was good try. The Tax Court seems to have agreed that Mr. Cantor could count some of the time that he spent on ABS Glass as a real estate trade or business. Presumably he could add that to the time he spent on the properties and if the total was more than 750 hours and more than he spent on other aspects of his glass business, he wins. As it happens, he did not have any detailed time records, so he lost.
What About That NAICS Code?
Most tax preparers won’t pay a lot of attention to numbers that don’t enter into the tax computation. One of those numbers is the code for the Schedule C business. The instructions point you to a list which is from the North American Industry Classification System. Generally it is just copied over from one year to the next, particularly if you are using software. If you are claiming your client is a real estate professional, maybe you should pay more attention to it. Would we have had a different outcome or maybe no audit at all, if the code had been 28150 Glass & Glazing Contractors?
Does The Tax Court Have A Favorite Dictionary?
The reference to the Webster’s II New Riverside University Dictionary made me wonder if that is somehow the official Tax Court dictionary. I found that it has been cited by the Tax Court 20 times which is twice as often as the Oxford English Dictionary. The higher courts seem to favor OED. Still you can get a copy from Amazon for one cent. Well, it’s four bucks when you throw in the shipping. Still, I decided to order myself a copy.