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.