Qualifying As A Real Estate Professional

 

The first thing I thought when I read the opinion was: this must have been a pro se case.

“Pro se”” has a specific meaning in Tax Court: it means that a taxpayer is not represented by a professional. Technically, this is not accurate, as I could accompany someone to Tax Court and they be considered pro se, but the definition works well enough for our discussion.

There is a couple (the Sezonovs) who lived in Ohio. The husband (Christian) owned an HVAC company and ran it as a one-man gang for the tax years under discussion.

In April 2013 they bought rental property in Florida. In November 2013 they bought a second. They were busy managing the properties:

·      They advertised and communicated with prospective renters.

·      They would clean between renters or arrange for someone to do so.

·      They hired contractors for repairs to the second property.

·      They filed a lawsuit against the second condo association over a boat slip that should have been transferred with the property.

One thing they did not do was to keep a contemporaneous log of what they did and when they did it. Mind you, tax law does not require you to write it down immediately, but it does want you to make a record within a reasonable period. The Court tends to be cynical when someone creates the log years after the fact.

The case involves the Sezonovs trying to deduct rental losses. There are two general ways you can coax a deductible real estate rental loss onto your return:

(1) Your income is between a certain range, and you actively participate in the property. The band is between $1 and $150,000 for marrieds, and the Code will allow one to deduct up to $25 grand. The $25 grand evaporates as income climbs from $100 grand to $150 grand.

(2)  One is a real estate professional.

Now, one does not need to be a full-time broker or agent to qualify as a real estate professional for tax purposes. In fact, one can have another job and get there, but it probably won’t be easy.

Here is what the Code wants:

·      More than one-half of a person’s working hours for the year occur in real estate trades or businesses; and

·      That person must rack-up at least 750 hours of work in all real estate trades or businesses.

Generally speaking, much of the litigation in this area has to do with the first requirement. It is difficult (but not impossible) to get to more-than-half if one is working outside the real estate industry itself. It would be near impossible for me to get there as a practicing tax CPA, for example.

One more thing: one person in the marriage must meet both of the above tests. There is no sharing.

The Sezonovs were litigating their 2013 and 2014 tax years.

First order of business: the logs.

Which Francine created in 2019 and 2020.

Here is what Francine produced:

                                     Christian              Francine

2013 hours                        405                      476                

2014 hours                         26                        80                 

Wow.

They never should have gone to Court.

They could not meet one of the first two rules: at least 750 hours.

From everything they did, however, it appears to me that they would have been actively participating in the Florida activities. This is a step down from “materially participating” as a real estate pro, but it is something. Active participation would have qualified them for that $25-grand-but-phases-out tax break if their income was less than $150 grand. The fact that they went to Court tells me that their income was higher than that.

So, they tried to qualify through the second door: as a real estate professional.

They could not do it.

And I have an opinion derived from over three decades in the profession: the Court would not have allowed real estate pro status even if the Sezonovs had cleared the 750-hour requirement.

Why?

Because the Court would have been cynical about a contemporaneous log for 2013 and 2014 created in 2019 and 2020. The Court did not pursue the point because the Sezonovs never got past the first hurdle.

Our case this time was Sezonov v Commissioner. T.C. Memo 2022-40.

Don’t Be A Jerk

 

I am looking at a case containing one of my favorite slams so far this year.

Granted, it is 2020 COVID, so the bar is lower than usual.

The case caught my attention as it begins with the following:

The Johnsons brought this suit seeking refunds of $373,316, $192,299, and $114,500 ….”

Why, yes, I would want a refund too.

What is steering this boat?

… the IRS determined that the Johnsons were liable for claimed Schedule E losses related to real estate and to Dr. Johnson’s business investments.”

Got it. The first side of Schedule E is for rental real estate, so I gather the doctor is landlording. The second side reports Schedules K-1 from passthroughs, so the doctor must be invested in a business or two.

There is a certain predictability that comes from reviewing tax cases over the years. We have rental real estate and a doctor.

COMMENT: Me guesses that we have a case involving real estate professional status. Why? Because you can claim losses without the passive activity restrictions if you are a real estate pro.

It is almost impossible to win a real estate professional case if you have a full-time gig outside of real estate.  Why? Because the test involves a couple of hurdles:

·      You have to spend at least 750 hours during the year in real estate activities, and

·      Those hours have to be more than ½ of hours in all activities.

One might make that first one, but one is almost certain to fail the second test if one has a full-time non-real-estate gig. Here we have a doctor, so I am thinking ….

Wait. It is Mrs. Johnson who is claiming real estate professional status.

That might work. Her status would impute to him, being married and all.

What real estate do they own?

They have properties near Big Bear, California.

These were not rented out. Scratch those.

There was another one near Big Bear, but they used a property management company to help manage it. One year they used the property personally.

Problem: how much is there to do if you hired a property management company? You are unlikely to rack-up a lot of hours, assuming that you are even actively involved to begin with.

Then there were properties near Las Vegas, but those also had management companies. For some reason these properties had minimal paperwork trails.

Toss up these softballs and the IRS will likely grind you into the dirt. They will scrutinize your time logs for any and every. Guess what, they found some discrepancies. For example, Mrs. Johnson had counted over 80 hours studying for the real estate exam.

Can’t do that. Those hours might be real-estate related, but the they are not considered operational hours - getting your hands dirty in the garage, so to speak. That hurt. Toss out 80-something hours and …. well, let’s just say she failed the 750-hour test.

No real estate professional status for her.

So much for those losses.

Let’s flip to the second side of the Schedule E, the one where the doctor reported Schedules K-1.

There can be all kinds of tax issues on the second side. The IRS will probably want to see the K-1s. The IRS might next inquire whether you are actually working in the business or just an investor – the distinction means something if there are losses. If there are losses, the IRS might also want to review whether you have enough money tied-up – that is, “basis” - to claim the loss. If you have had losses over several years, they may want to see a calculation whether any of that “basis” remains to absorb the current year loss.

 Let’s start easy, OK? Let’s see the K-1s.

The Johnson’s pointed to a 1000-plus page Freedom of Information request.

Here is the Court:

The Johnsons never provide specific citations to any information within this voluminous exhibit and instead invite the court to peruse it in its entirety to substantiate their arguments.”

Whoa there, guys! Just provide the K-1s. We are not here to make enemies.

Here is the Court:

It behooves litigants, particularly in a case with a record of this magnitude, to resist the temptation to treat judges as if they were pigs sniffing for truffles.”

That was a top-of-the-ropes body slam and one of the best lines of 2020.

The Johnsons lost across the board.

Is there a moral to this story?

Yes. Don’t be a jerk.

Our case this time was Johnson DC-Nevada, No 2:19-CV-674.

Why Does The IRS Want A Disabled Veteran To Work Faster?

Sometimes I read a tax case and ask myself “why did the IRS chase this?”

Lewis is one of those cases.

Let’s explain the context to understand what the IRS was after.

It will soon be three decades that Congress gave us the “passive activity” (PAL) rules. A PAL is a trade or business that you do not sufficiently participate in – that is, you are “passive” in the business. This means more when you have losses from the activity, as income is going to be taxed in any event. It was Congress’ intention to take the legs out from the tax shelters, and with PALs they have been largely successful.

The PAL rules got off to a rocky start. One of the early problems was Congress’ decision to classify real estate activities as passive activities. Now, that concept may make sense if one own a duplex a few streets over, but it doesn’t work so well if one is a home builder or property manager.

Say, for example, that a developer builds a hundred condo units. The real estate market reverses, and he/she cannot sell them as quickly as planned. The developer rents the units, waiting for the market to improve.

Most of us would see one activity. Congress saw two, as the rental had to be segregated. There was no harm if both were profitable. There was harm if only the development was profitable, however, as the rental loss would just hang in space until there was rental income to absorb it.

That was the point of the passive activity rules – to disallow the use of passive losses against nonpassive income.

Real estate professionals screamed about the unfairness of the law as it applied to their industry.

And Congress changed the law by making an exception for real estate people who:

(1) Work more than 750 hours during the year in real estate, and

(2) More than one-half of all hours worked were in real estate.

If you meet both of the above tests, you can deduct losses from your real estate activities to your heart’s content.

Bill Lewis is a Vietnam veteran. He took injuries as a Marine, retaining 50 percent use of his right arm and 70 percent of his feet, requiring him to wear orthopedic shoes. The military gave him a disability pension. He now needs knee surgery, and he has difficulty seeing. He is married.

He and his wife own a triplex next door to their residence. The property also has a washhouse, although I am uncertain what a washhouse is. There are six 64-gallon recycling bins, and several large walnut trees. Mr. Lewis does not ask anyone to take care of his property. He takes care of it himself.

1.  Every morning he walks around and inspects for trash, as they are located very close to a homeless area.  This takes him about a half hour daily.
2. Also on Mondays he scrubs down the washhouse. That requires him to haul water and takes him about three hours. 
3. On Tuesdays and Thursdays he landscapes, cleans the outside of the buildings and the garbage cans and rakes the yard. This takes about two hours on each day.
4. Depending on the season, he has more raking to do, as he has walnut trees on the property.
5. On Wednesdays he takes the recycling bins out to the curb. One by one, as he has mobility issues.
6. On Thursdays he returns the recycling bins. Same mobility issues.
7. He prefers to do repairs himself. If he needs outside help, he schedules and meets with that person. 
8. He follows a set routine, rarely if ever taking a vacation.

The Lewis’ claimed rental losses for 2010 and 2011. The IRS disallowed the losses and wanted almost $11,000 in taxes in return. The IRS said this was the classic passive activity.

The IRS should have also taken candy from a child and kicked a dog and made this a trifecta of bad choices.

Mr. Lewis was disabled. He did not have a job. As a consequence, he did not have to worry about spending more than half of his work hours in real estate. For him, all of his work hours were in real estate.

But Mr. Lewis ran into two issues:

(1)  He did not keep a journal, log or record of his activities and hours; and

(2)  The IRS did not believe it could possibly take more than 750 hours to do what he did.

Issue (1) is classic IRS. I have run into it myself in practice. The IRS wants contemporaneous records, and few people keep time sheets for their real estate activities. The IRS then jumps on after-the-fact records as “self-serving.” The IRS has been aided by people who truly could not have spent the hours they claimed (because, for example, they have a full-time job) as well as repetitively fabulist time records, and the courts now routinely side with the IRS on this issue.

But not this time. The judge was persuaded by the Lewis’ testimony and the few records they could provide. This was a rare win for the taxpayer.

The IRS had a second argument though: it should not have taken as long as it took Mr. Lewis to perform the tasks described.

The judge dismissed this point curtly:

Petitioner husband and petitioner wife testified credibly that because of petitioner husband’s disabilities all of the activities took him significantly longer than might ordinarily be expected.”

The Lewis’ won and the IRS lost.

Good.

These were very unique facts, though. Unless one truly works in the real estate industry, many if not most are going to lose when the IRS presses on contemporaneous records for the 750 hours. Mr. Lewis was a sympathetic party, and the judge clearly gravitated to his side.

Which raises the question: why did the IRS pursue this? They were anything but sympathetic chasing a disabled veteran for taking too long while performing his landlord responsibilities.

Yes, I am sympathetic to Mr. Lewis too.

The IRS Updates a Real Estate Professional Tax Rule

I am glad to see that the IRS has reversed course on an issue concerning real estate professionals.

You may remember that “passive losses” entered the tax Code in 1986 as retaliation against tax shelters. The IRS had previously battled tax shelters using challenges such as “at-risk,” but 1986 brought a new and updated weapon to the IRS armory.

The idea is simple: separate business activities into two buckets: one bucket for material participation and a second for passive. The classic material participation is an activity where one works more than 500 hours. Activities in the material participation bucket can offset each other; that is, losses can offset income.

Move on to the second bucket. Losses can offset income – but not beyond zero. The best one can do (with exceptions, of course) is get to zero. One cannot create a net loss to offset against net income from bucket one.

Consider that tax shelters were placed into bucket two and you understand how Congress changed the tax Code to pull the rug out from under the classic tax shelter.

It was quickly realized that the basic passive activity rules were unfair to people who made their living in real estate. For example, take a real estate developer who keeps a few self-constructed office condominiums as rentals. If one went granular separating the activities, then the real estate development would be a material participation activity but the condominium rentals would be a passive activity. This result does not make sense, as all the income in our example originated from the same “activity.”

So Congress came in with Section 469(c)(7):

   469(c)(7) SPECIAL RULES FOR TAXPAYERS IN REAL PROPERTY BUSINESS.—

469(c)(7)(A) IN GENERAL.— If this paragraph applies to any taxpayer for a taxable year—

469(c)(7)(A)(i)   paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

469(c)(7)(A)(ii)   this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

469(c)(7)(B) TAXPAYERS TO WHOM PARAGRAPH APPLIES.— This paragraph shall apply to a taxpayer for a taxable year if—

469(c)(7)(B)(i)   more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

469(c)(7)(B)(ii)   such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Look at Section 469(c)(7)(B)(ii) and the reference to 750 hours. There was confusion on what happened to the plain-vanilla 500-hour rule. Was a real estate pro to be held to a higher standard?

Here for example is the Court in Bahas:

Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to Section 469(c)(7)(A) petitioners must treat each of these interests in the real estate as if it were a  separate activity. Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.”

How in the world did we get from 500 hours to 750 hours for each of Mrs. Bahas’ activities?  This is not what Section 469(c)(7) appears to say. There was a torrent of professional and academic criticism on Bahas and related decisions, but in the interim practitioners (me included) elected to aggregate all the real estate activities into one activity. Why? To make sure that one got to the 750 hours, that is why.

Academicians could argue the sequence of phrases and the intent of the law. Practitioners had to prepare annual tax returns, protect their clients and wait their time.

And now it is time.

The IRS released ILM 201427016 to discuss how the “750-hour test” works when one has multiple real estate activities. It includes the following obscuration:

However, some court opinions, while reaching the correct result, contain language which may be read to suggest that the election under Treas. Reg. 1.469-9(g) affects the determination of whether a taxpayer is a qualified taxpayer.”

The IRS finally acknowledged that the 750-hour rule is not a substitute or override for the generic 500-hours-to-materially-participate rule. A real estate taxpayer goes activity-by-activity to determine if he/she is materially participating in each activity. If it is advantageous, the taxpayer can also make an election to aggregate all real estate activities before determining material participation status.

Then, once all that is done, the IRS will look at whether the taxpayer meets the more-than-half and more-than-750-hours tests to determine whether the taxpayer is a real estate pro.

There are two separate tests. One is to determine material participation and a second to determine real estate pro status. 

A bit late for Mrs. Bahas, though.

Sometimes the IRS Just Doesn't Believe You

I was reading the following recently, and we will use it as a springboard for our discussion today:

In its continued assault on real estate investors, the Court held in Jafarpour and Prang v. Commissioner, …, the taxpayers were not actively involved in a real estate trade or business nor was she a real estate professional ….

Prang is just one more taxpayer to fall under the IRS’s aggressive assault on real estate investors.

That writer and I do not agree on Jafarpour and Prang (“Prang”).

We are talking today about the taxation of real estate activities. Ever since 1986 we have had the passive activity rules, which Congress used to address the problem of tax shelters. The overall concept is simple: if an activity is considered to be passive, then losses from the activity cannot be subtracted from income considered nonpassive. Here is an example: you will not be allowed to claim losses or tax credits from an Alpaca investment against your W-2 income and bonus.

There are exceptions for real estate activities. This is not surprising, considering how significant real estate is to the national economy. The exception that Prang wanted was the “real estate professional” exception. If she could attain that, then her real estate activities would be nonpassive. She could subtract losses to her heart’s content.

There are two basic requirements to being a real estate pro:

(1)   More than one-half of your work hours have to be real-estate related, and

(2)   You have to work more than 750 hours in real estate

We have several real estate pro clients. A builder or broker qualifies, for example. These guys work real estate full-time, so they are easy to identify. What if you mix real estate with non-real estate activities? Further, what if the total hours are close?  You had better keep good records. That gets us to Prang.

Jafarpour was the husband. He sold stock options in 2006.

Prang was the wife. She was a chiropractor. Unfortunately she got injured and sold her practice during the middle of 2006.

So Prang and her husband came into cash and were looking for something to do. They have some experience in real estate. They have rented a former residence in California for a decade, for example. She attended seminars on real estate investing, including a course at the community college. The community college instructor explained the additional depreciation available for Katrina-affected areas (referred to as the GO Zone).

Mrs. Prang liked the idea and they snapped up three properties in Louisiana and Alabama. They almost immediately signed contracts with management companies to handle the properties. After all, they live almost 2,000 miles away. They returned to California.

They claimed over $271,000 in real estate losses on their 2006 tax return. Surprisingly, this caught the IRS’ attention. They were audited.

Jafapour immediately admitted that he was not a real estate pro for 2006. Not a problem, as Mrs. Prang claimed that she was the real estate pro. The IRS said: let’s go through the math: how many hours did you work and how many hours were in real estate?

The way to prove this is to show a record or log, preferably kept contemporaneously, showing what you did and how long it took. Mrs. Prang had an appointment book at the chiropractic office, so that should establish the chiropractic hours. The IRS looked at it and had questions. Daily visits were often illegible. There were daily totals, but the IRS was unable to determine what the totals represented. The totals frequently did not coincide with the number of patients filled-in for the day or the hours Mrs. Prang was supposedly working. Prang deepened the hole by attesting that she left the practice after selling in June. However there were e-mails and notations that she was still involved.

The IRS moved over to the real estate logs. The log was divided into sections. Immediately they were curious because she wrote her activities in pen but the number of hours in pencil. Mrs. Prang explained that she did this so she could cross-reference her time with phone records and make adjustments. Flipping through, the IRS saw several times the same task recorded in multiple sections. More than once the amount of time seemed excessive for the task. For example, Prang noted that she spent one hour on November 8, 2006 reading the following e-mail:

Hi Lecia, I'm your loan processor and will be your main contact person from this point on. I received the FedEx package you sent back. I will review it and prepare the file for my underwriter to review. I will update you with the status within 3 business days."

So she was a slow reader. The IRS pressed on. They spotted several days where she said he worked 17 or more hours, which was impressive. Problem is that she noted the same tasks on more than one day. She described doing something while she was actually on a plane back to California, which would have been a Copperfield-worthy trick. Some of the e-mails she claimed to have sent were from her husband’s e-mail account - and electronically signed by her husband.

The IRS came to the conclusion that she manufactured the logs after-the-fact, which greatly weakened their credibility. She worked the logs to get the answer she wanted. The IRS trusted none of it, denied her real estate professional status and disallowed her loss.

Prang went to Tax Court. Here is the Court:

We would have to engage in complete guesswork to determine how much time Ms. Prang spent at her chiropractic business on a particular day during 2006, let alone the entire year. We decline to engage in such dubious speculation.”

We are not convinced that Ms. Prang contemporaneously recorded her actions in the real estate log. Petitioners' unreasonable assertions are so pervasive that the entire log is tainted with incredibility. Moreover, petitioners' appointment book is frequently illegible and generally ambiguous. While Ms. Prang may have invested a considerable amount of time in real estate activities during 2006, petitioners' records are simply too unreliable for us to draw any sound conclusion.”

The Tax Court found the logs unreliable. With them she couldn’t prove her real estate pro status. Without that status she could not claim losses. Without the losses she owed the IRS a lot of money. And she owed a big penalty.

My Take:  I have had a real estate pro audit before, and the IRS challenged the logs directly. I was younger and working under a partner at another firm. In that case, I felt that the examining agent and supervisor were being unreasonable. The client had maintained but had not assembled the data into a usable, calendar form.  The agent felt that fact impugned the log, whereas my argument was that the log was little more than an administrative compilation of existing data. The agent disallowed pro status, the group manager sided with the agent, we appealed and won in Appeals. Quite a hassle - and we had better facts than Prang. For all that the client fired us. It did not go as smoothly as he would have liked. I wasn’t too thrilled about it either.

I try to be blunter with clients these days about the hazards of tax representation. Lose the examiner’s trust, for example, and you may not convince him/her that the sun came up this morning. Catch the examiner on a pet peeve and he/she may raise the body more often than a Living Dead episode. You may have an examiner too green to realize that classroom examples rarely occur outside the classroom. You may run into a coordinated exam, in which a specialized group – not necessarily the examiner - is calling the shots.  A lot can go wrong.

Was Prang an “aggressive assault” on real estate investors? I do not see it. What I do see is someone gaming the system. They got caught. That’s all.