Whose Job Is It Anyway?

One of our accountants asked me recently:

R:      Do you think [so and so] qualifies as a real estate professional?

CTG: I do not know [so and so]. Tell me a little.

R:      Husband pulls a W-2.

CTG: How much and how many hours?

R:      Blah blah dollars.

CTG: Works in real estate?

R:      Nah.

CTG: Hours?

R:      Maybe 2,000.

CTG: Is the wife in real estate?

R:      No.

I have told you (almost) everything you need to answer the question.

Let’s look at the Warren case.

James Warren organized Warren Assisted Living, LLC in 2015.

He purchased a group home in 2016.

He started repairing the home almost immediately.

In 2017 he worked at Lockheed Martin for 1,913 hours as an engineer.

On his 2017 tax return he claimed a $41 thousand-plus loss from the group home. He claimed he was a real estate professional.

Warren did not keep time logs.

What sets this up are the passive activity rules under Section 469. As initially passed, that Section considered rental activities (with minimal exceptions) to be “per se” passive.

The passive activity rules would then stifle your ability to claim losses. You – for the most part – had to wait until you had income from the activity. You could then use the losses against the income. 

Well, that caught real estate landlords and others around the country by surprise. When you do one thing, it is difficult to have a Congressional staffer decide that your thing is not a regular thing like the next thing across the street.

Congress made a change.

(c)(7)  Special rules for taxpayers in real property business.

 

(A)  In general. If this paragraph applies to any taxpayer for a taxable year-

 

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

(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.

 

(B)   Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if-

 

(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

(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.

 

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

The above is called the real estate professional exception. It is a mercy release from the per se rule that would otherwise inaccurately (and unfairly) consider people who work in real estate all day to not be working at all.

It has two main parts:

(1) You have to spend at least 750 hours working in real estate, and

(2)  You have to spend more than 50% of your “working at something” total hours actually “working in real estate.”

If you are a real estate professional, you avoid the “per se” label. You have not yet escaped the passive activity rules – you still have to show that you worked - but at least you have the opportunity to present your case.

The Court looked at Warren’s 1,913 hours at Lockheed. That means he would need 3,827 total hours for real estate to be more than ½ of his total work hours. (1,913 times 2 plus 1).

First of all, 3,827 total hours means he was working at least 74 hours a week, every week, without fail, for the entire year.

Maybe. Doubt it.

Warren is going to need really good records to prove it.

Here is the Court:

Mr Warren did not keep contemporaneous logs of his time renovating the group home.”

Not good, but not necessarily fatal. I represented a client who kept Outlook and other records. She created her log after the fact but from records which themselves were contemporaneous. Mind you, we had to go to Appeals, but she won.

In preparation for trial, Mr Warren created – and presented – two time logs.”

Good grief.

The first log maintained that he worked 1,421 hours at the group home; it was created one week before trial.”

End it. That is less than his 1,913 hours at Lockheed.

The second log maintained that Mr. Warren worked 1,628 at the group home; it was created the night before trial.”

Why bother?

This was a slam dunk for the Court. They did not have to dwell on contemporaneous or competing logs or believability or whether the Bengals will turn their season around. Whether 1,421 or 1,628, he could not get to more-than-50%.

Warren lost.

As a rule of thumb, if you have a full-time W-2, it will be almost impossible to qualify as a real estate professional. The exception is when your full-time W-2 is in real estate, maybe with an employer such as CBRE or Cushman & Wakefield.  At 1,900-plus Lockheed hours, I have no idea what Warren was thinking, although I see that it was a per se case. That means he represented himself, and it shows.

I suppose one could have a W-2 and work crazy hours and meet the more-than-50% requirement, but your records should be much tighter. And skip the night before thing.

BTW another way to meet this test is by being married.

Look at (B)(ii) again:

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

If your spouse can meet the test (both parts), then you will qualify by riding on the shoulders of your spouse.

Our case this time was Warren v Commissioner, T.C. Summary Opinion 2024-20.

A Job, A Gig and Work Expenses

 

The case is straightforward enough, but it reminded me how variations of the story repeat in practice.

Take someone who has a W-2, preferably a sizeable W-2.

Take a gig (that is, self-employment activity).

Assign every expense you can think of to that gig and use the resulting loss to offset the W-2.

Our story this time involves a senior database engineer with PIMCO. In 2015 he reported approximately $176,000 in salary and $10,000 in self-employment gig income.  He reported the following expenses against the gig income:

·      Auto      $14,079

·      Other     $12,000

·      Office    $ 7,043

·      Travel    $ 6,550

·      Meals     $ 3,770

There were other expenses, but you get the idea. There were enough that the gig resulted in a $40 thousand loss.

I have two immediate reactions:

(1)  What expense comes in at a smooth $12,000?

(2)  Whatever the gig is, stop it! This thing is a loser.

In case you were curious, yes, the IRS is looking for this fact pattern: a sizeable (enough) W-2 and a sizeable (enough) gig loss.

In general, what one is trying to do is assign every possible expense to the gig. Say that one is financial analyst. There may be dues, education, subscriptions, licenses, travel and whatnot associated with the W-2 job. It would not be an issue if the employer paid or reimbursed for the expenses, but let’s say the employer does not. It would be tempting to gig as an analyst, bring in a few thousand dollars and deduct everything against the gig income.

It’s not correct, however. Let’s say that the analyst has a $95K W-2 and gigs in the same field for $5k. I see deducting 5% of his/her expenses against the gig income; there is next-to-no argument for deducting 100% of them.

The IRS flagged our protagonist, and the matter went to Court.

We quickly learned that the $10 grand of gig income came from his employer.

COMMENT: Not good. One cannot be an employee and an independent contractor with the same company at the same time. It might work if one started as a contractor and then got hired on, but the two should not exist simultaneously.

Then we learn that his schedule of expenses does not seem to correlate to much of anything: a calendar, a bank account, the new season release of Stranger Things.

The Court tells us that his “Travel” is mostly his commute to his W-2 job with PIMCO.

You cannot (with very limited exception) deduct a commute.

There were some “Professional Fees” that were legit.

But the Court bounced everything else.

I would say he got off well enough, all things considered. Please remember that you are signing that tax return to “the best of (your) knowledge and belief.”    

Our case this time was Pilyavsky v Commissioner.

An Engineer Draws A Tax Penalty

We have spoken in the past about clients I would not accept: one with an earned income credit, for example. The tax Code requires me to go all social worker, obtaining and reviewing documents to have reasonable confidence that there is a child and said child lives in given household. There are penalties if I do not.

Not happening.

Did you know that I can be penalized for not signing a tax return as a paid professional? Yep, it is in Section 6694 for the home gamers.

I saw a penalty recently under Section 6701. That one is a rare bird.

The 6701 penalty can reach someone who is not a preparer but who “aids,” “assists” or “advises” with respect to information, knowing that it will be used in a material tax situation.

Here is an example: you gift majority control of your (previously) wholly-owned business to your kids. This would require a valuation, which in turn requires a valuation expert. That expert is probably not preparing the gift tax return, but the preparer of the gift tax return is relying – and heavily – on his/her work.

The penalty is $1,000 for each incident. Pray that you are not advising a corporation, as then it goes to $10,000 per incident.

The IRS recently trotted out Section 6701 in Chief Counsel Advice (CCA) 201805001. Think of a CCA as an IRS attorney advising an IRS employee on what to do.

The situation here involved a “tax-consultant engineer” who analyzed a taxpayer’s assets to determine the classification of property for depreciation purposes.

In the trade, we call this type of work “cost segregation.”

If you have enough money tied-up in certain types of depreciable assets, a “cost seg” may be a very good idea.

What drives the cost seg is an abnormally-long tax life for commercial property: usually 39 years.  It is a tax fiction, divorced from any economic analysis to build or not build or from a bank decision to lend or not lend.

The grail is to “carve out” some of that 39-year property into something that can be depreciated faster. There is room. The parking lot and landscaping, for example, can be depreciated over 15 years. Upgraded wiring to run equipment can be depreciated with the equipment. The additional plumbing at a dentist’s office? Yep, that gets faster depreciation.

But it probably requires a cost seg. Realistically, an accountant can do only so much. A cost seg really needs an engineer.

The engineer in this CCA must have left the plot, as the IRS was nearly out-of-its-mind over his classification into five-year property. The word they used was “egregious.”

Unfortunately, we are not told what he “egregiously” misclassified.

We are however told that he is getting the Section 6701 chop.

What is the math on this penalty?

Well, his misclassification affected five years of individual returns. The penalty would be 5 times $1,000 or $5,000 for each individual client. Hopefully this was a one-off, as $5 grand should be enough to get his attention.

Can you imagine if it had been a corporation?