Originally published on Forbes.com.
Trying to qualify as a real estate professional, while holding a substantial day job, is a serious challenge. Most who try fail, but their attempts can be a source of instruction and amusement to the rest of us. This recent decision of the State of New York, Division of Tax Appeals might have broken new ground. Although this is public record, I’m referring to the taxpayer in the case as TP. He seems to have a pretty low internet profile and I’m not going to be the one to raise it.
TP tried to make the case that, at least from the point of view of time spent, his day job was not that demanding. That did not go well. Also, we learn that presenting alternate facts on top of previous facts is not a good way to respond to a tax audit and the resulting litigation. We’ll start with just a bit of background. At stake were losses of $73,769 for the year 2009, which made for a tab to New York over $10,000, when interest and penalties are included.
The Issue
Code Section 469, the passive activity loss rules, requires us to divide our business activities into passive and non-passive buckets. If the passive bucket overflows with losses, they cannot be used currently. They are suspended to be used only against future passive income or when the associated activity is fully disposed. A further rule, kind of an insult to anybody involved in renting out properties, is that rental activities are per se passive.
There is an exception to the per se passive rule for people engaged in real estate trades or businesses. There are some technical points and elections to consider, but someone who mostly busies himself working in real estate business that he owns can avoid the per se passive rule. One hurdle that is fairly easy is 750 hours a year. Owning rental real estate is a series of one GD after another. So having it ruin most of your weekends and quite a few evenings is altogether plausible. That would get you to 750.
There is a bigger challenge to would be real estate pros. You have to spend more time on your real estate trades or businesses than you do on anything else. This is close to an insurmountable obstacle to most part-time landlords, when they are challenged on audit. Judges tend to be very skeptical about the time claims of would be real estate pros. TP failed to overcome that skepticism, although it was not from want of trying.
Spare Time At Work
I’ve noticed that most people tend to emphasize how busy and pressured they feel at work. In order to solve the real estate pro problem, TP took the opposite tack. He argued that he had time while doing his day job to work on his rental properties. This is a bit reminiscent of a would-be real estate pro who worked at a power plant. He counted as real estate time, the time he was on call for his tenants. TP’s argument is brilliant in its way. Remember your real estate time has to beat your day job time, so taking time away from the day job to work on real estate could do double duty. That is the theory that he put forth in a letter to the Division of Taxation in 2012.
The letter set forth that petitioner worked 37.5 hours per week, for a total of 1,950 hours, which included his vacation time. Petitioner stated that he performed real estate activities such as tenant interviews and service appointments during hours spent working for ______. Through his employment at ____, petitioner was responsible for seven employees who reported directly to him, and these seven employees also had _____ employees who reported to them, and as a result, petitioner claimed that he had a lot of free time to do other things during his full-time work schedule at ____. (TP’s employer redacted)
The Logs
TP also submitted work logs for the five properties that he owned. They totaled 2,364 hours including 2,089 hours on a single property. The auditors for the state claimed that the hours that TP spent interviewing tenants and making service appointments while at his day job could not be counted. They also wanted a better log
An acceptable time log would include an entry for each day and it would include the date you performed the activity, a description of the activity and the amount of time spent on the activity. You are required to provide proof of the activities performed and hours attributable to those activities as indicated in federal regulation 1.469-5T(f)(4).
TP submitted an additional 55 pages of documentation including a 16 page year-end summary of his credit card. The latter was not much help.
Although the vendor is displayed in the summary, there is no way to determine what each charge reflects. In other words, without the ability to review receipts, it is unclear what was purchased, making it impossible to determine if it related to the claimed real estate activities. Moreover, petitioner did not testify whether this credit card was exclusively used for the rental properties.
Worse was the fact that the information in the second submission was significantly different from the first.
According to the time logs provided with your protest dated 02/03/13, the total time you spent working on the rentals was 1,483 hours. In your original reply dated 10/20/12, you stated you spent 2,364 hours working on the rentals and 1,725 hours spent working at . Additionally, the hours you stated for each property in your protest did not match the hours claimed in your original reply. Based on the time provided in your protest, you would not meet test one of the real estate professional qualification. Additionally, we noted numerous discrepancies between the time logs.
Alternate Facts
At the hearing TP discussed the differences between the two logs and then submitted a third log, which was, by his account, even more reliable. And then there were the computer issues
Petitioner also claimed to keep very detailed logs, by inputting information contemporaneously into his cellphone, which he then entered into an Excel spreadsheet. He claimed that he was unable to print out the spreadsheet due to the fact that the output would be wide, i.e. wider than standard letter-sized paper. Petitioner states that he converted the information to a PDF format in order to print it. Moreover, petitioner stated that the Division required that the information be presented to it in paper form and it could not be supplied through email communication.
It did not go well for TP
In reviewing the exhibits, there are three different work logs that became increasingly more detailed as time went by. For this reason, it is determined that the work logs are simply unreliable. It cannot be found that the information contained within the logs was contemporaneously maintained. It is inconceivable that petitioner’s recollection of purchases and repairs on five rental properties would be clearer in 2016, when he testified, rather than in 2012 and 2013 when presenting the information on audit. For this reason, it is determined that petitioner’s testimony lacked credibility
Likewise, petitioner’s testimony with respect to changing the format of his Excel spreadsheet in order to print the information does not make any sense (see Finding of Fact 15). There is ample ability to print out Excel spreadsheets. The only reason to change document formats is if the recipient of an email does not have the software to open a document. Since petitioner stated that the Division would not accept email transmissions, his explanation for his failure to supply the requested, detailed information is without merit.
States Picking Up The Slack?
New York, like many states with income taxes, uses federal income as a starting point. This can allow the states a free ride on IRS audits. As IRS audit coverage declines, we can expect that some of the state revenue departments might get more aggressive on their own account even though they are dealing with federal issues. This will also result in different outcomes on your federal and state returns in some cases making for different carryovers and hopelessly complicated returns in future years.
So You Want To Be A Real Estate Pro
The substantiation standards that would be real estate pros with full-time day jobs are held to are close to insurmountable. If you are going to try it, you need contemporaneous logs that ideally will correlate with things like invoices and phone records. Given that you are already working something like eighty hours a week between your properties and your day job, it is hard to see how you will get it done. Losing on the issue is not necessarily the end of the world, since your deductions are suspended and will be used when you finally start making money or dispose of properties.
Other Coverage
MoFo New York Tax Insights has a brief piece on the case on page 8, but that is pretty much it.