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.

Some Thoughts After The Tax Filing Deadline(s)

 

There is something happening in the public accounting profession. The profession itself is aging. The AICPA expected 75% of practicing CPAs to reach retirement age by 2020 – which was four years ago. Many smaller firms do not have succession plans, meaning that an owner’s retirement plan likely involves being acquired by another firm. Fewer college students are pursuing accounting majors, placing stress on recruiting and retaining accountants in the early years of their career. We see firms releasing clients and sometimes entire lines of practice. I know of one which released its trust work, which surprised me. I contributed to this several years ago when we released our inbound (that is, international) work. These clients still need professional advice, but fewer CPAs are providing these services.

On the flip side, it is a great time for someone to start (or grow) an accounting practice. A challenge here is step growth – that is, growth that requires hiring. One circles back to the issue of the talent shortage. A bad hire is damaging, perhaps even more so in a small firm.

Even the IRS is not immune to the talent shortage. In 2019 the IRS employed approximately 75,000 people. The Inflation Reduction Act supposedly provided funds to hire an additional 87,000 people through the year 2031. It hasn’t, of course, as the IRS is competing with every other employer in the market.

I suspect the profession has done much of the damage to itself. One can easily point to the 150-hour requirement for a CPA license. That may have made sense years ago, but with today’s exorbitant college costs that additional year of class, books and housing might be difficult to justify.

And then we have the toxicity of the profession itself. I cannot recall the last time that a CPA my age has not shared his/her “horror” stories: the stress, hours, near-impossible deadlines, psychopathic personalities, power dynamics and whatnot. I remember a managing partner bringing cigars so we could “talk”; we sat outside, and he explained how infeasible it was for me to visit my ailing grandmother in Florida. My grandmother died that year. I also left the firm that year. I suspect Gen Z will not tolerate this behavior as passively, and rightfully so.   

Congress has greatly exacerbated the problem with its never-ending and wildly metastasizing tax changes. It used to be that accountants would spread their tax work over the course of the year by placing their business clients on a fiscal year – that is, a tax year ending other than December 31. This allowed work to be distributed more sanely over the year. Congress changed this in 1986 by requiring almost everyone to use the calendar year. Yes, there was an “out,” and the out was for the business to pay a “deposit” for taxes it would have paid had it changed to a calendar year. I suspect that – even if not a CPA – you can guess how well those client conversations went. Combine that with Congress’ recent-enough 1099 reporting fetish and you have a crippling steamroller than begins in January and ends … well, who know when.  

I think we overstretched ourselves here at Galactic Command this year. Potential clients are calling for appointments, and it can be hard (for some of us) to say no. After the just-concluded September and October extension deadlines, however, we must learn to say no. We do not have the resources, and we are burning the resources – including me – that we do have.    

Then there is AI – will artificial intelligence replace any/some/much of what a CPA does? Depending on what the accountant does, I suppose it is possible. First year audit work, for example, scarcely requires a 150-hour degree. That might be a viable onramp for AI. Then again, I remember when QuickBooks was going to put accounting services departments out of business. It didn’t, and accounting services is one of the most sought-after practice areas in accounting firms today. Will AI take away much of my 1040 workload? 

I hope so.

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.

Do You Have To Register To Be Considered A College Student?

I cannot believe this case made it to the Tax Court.

Granted, it is a "pro se" decision, which means that the taxpayer represented himself/herself. It sometimes is the professional wrestling of tax literature.

I will give you the facts, and you can tell me how the case was decided.

Through 2012 Brittany was a student at Saddleback College (Saddleback) in Mission Viejo, California. Our story takes place in the spring, when Brittany registered for a five-hour physiology course.  She also attended (for eight weeks, at least) a contemporary health course, although she never registered or enrolled in the course.

She filed her 2012 tax return and claimed a $2,500 American Opportunity tax credit. This is the credit for the first four years of college.

The IRS bounced the return. It pointed out the following from Code section 25A:

(B) Credit allowed for year only if individual is at least 1/2 time student for portion of year

The Hope Scholarship Credit under subsection (a)(1) shall not be allowed for a taxable year with respect to the qualifies tuition and related expenses of an individual unless such individual is an eligible student for at least one academic period which begins during such year.

The term "eligible student" in turn is defined as one carrying at least half the normal full-time workload at school.

The IRS saw a five-hour load and did not see an eligible student.

Brittany did not see it that way. She saw a five-hour load and her sitting-in on a three-hour course. That added up to eight hours, which was more than half-time.

What did the Tax Court decide?

We do not need Apple's tax department for this one.

The Regulations require that a student enroll at the school. And the course. Each course.

Five hours was not enough to be half-time. She did not qualify for the credit.