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.

Reorganizing A Passive Activity

 

I am looking at a case that stacks a couple of different tax rules atop another and then asks: are we there yet?

Let’s talk about it.

The first is something called the continuity of business doctrine. Here we wade into the waters of corporate taxation and - more specifically - corporate reorganizations. Let’s take an easy example:

Corporation A wants to split into two corporations: corporation B and corporation C.

Why? It can be any number of things. Maybe management has decided that one of the business activities is not keeping up with the other, bringing down the stock price as a result. Maybe two families own corporation A, and the two families now have very strong and differing feelings about where to go and how to get there. Corporate reorganizations are relatively common.

The IRS wants to see an active trade or business in corporations A, B and C before allowing the reorganization. Why? Because reorganizations can be (and generally are) tax-free, and the IRS wants to be sure that there is a business reason for the reorganization – and avoiding tax does not count as a business reason.

Let me give you an example.

Corporation A is an exterminating company. Years ago it bought Tesla stock for pennies on the dollar, and those shares are now worth big bucks. It wants to reorganize into corporation B – which will continue the exterminating activity – and corporation C – which will hold Tesla stock.

Will this fly?

Probably not.

The continuity of business doctrine wants to see five years of a trade or business in all parties involved. Corporation A and B will not have a problem with this, but corporation C probably will. Why? Well, C is going to have to argue that holding Tesla stock rises to the level of a trade or business. But does it? I point out that Yahoo had a similar fact pattern when it wanted to unload $32 billion of Alibaba stock a few years ago. The IRS refused to go along, and the Yahoo attorneys had to redesign the deal.

Now let’s stack tax rules.

You have a business.

To make the stack work, the business will be a passthrough: a partnership or an S corporation. The magic to the passthrough is that the entity itself does not pay tax. Rather its tax numbers are sliced and diced and allocated among its owners, each of whom includes his/her slice on his/her individual return.

Let’s say that the passthrough has a loss.

Can you show that loss on your individual return?

We have shifted (smooth, eh?) to the tax issue of “materially participating” and “passively nonparticipating” in a business.

Yep, we are talking passive loss rules.

The concept here is that one should not be allowed to use “passively nonparticipating” losses to offset “materially participating” income. Those passive losses instead accumulate until there is passive income to sponge them up or until one finally disposes of the passive activity altogether. Think tax shelters and you go a long way as to what Congress was trying to do here.

Back to our continuity of business doctrine.

Corporation A has two activities. One is a winner and the other is a loser. Historically A has netted the two, reporting the net number as “materially participating” on the shareholder K-1 and carried on.

Corporation A reorganizes into B and C.

B takes the winner.

C takes the loser.

The shareholder has passive losses elsewhere on his/her return. He/she REALLY wants to treat B as “passively nonparticipating.” Why? Because it would give him/her passive income to offset those passive losses loitering on his/her return.

But can you do this?

Enter another rule:

A taxpayer is considered to material participate in an activity if the taxpayer materially participated in the activity for any five years during the immediately preceding ten taxable years.

On first blush, the rule is confusing, but there is a reason why it exists.

Say that someone has a profitable “materially participating” activity. Meanwhile he/she is accumulating substantial “passively nonparticipating” losses. He/she approaches me as a tax advisor and says: help.

Can I do anything?

Maybe.

What would that something be?

I would have him/her pull back (if possible) his/her involvement in the profitable activity. In fact, I would have him/her pull back so dramatically that the activity is no longer “materially participating.” We have transmuted the activity to “passively nonparticipating.”

I just created passive income. Tax advisors gotta advise.

Can’t do this, though. Congress thought of this loophole and shut it down with that five-of-the-last-ten-years rule.

This gets us to the Rogerson case.

Rogerson owned and was very involved with an aerospace company for 40 years. Somewhere in there he decided to reorganize the company along product lines.

He now had three companies where he previously had one.

He reported two as materially participating. The third he treated as passively nonparticipating.

Nickels to dollars that third one was profitable. He wanted the rush of passive income. He wanted that passive like one wants Hawaiian ice on a scorching hot day.

And the IRS said: No.

Off to Tax Court they went.

Rogerson’s argument was straightforward: the winner was a new activity. It was fresh-born, all a-gleaming under an ascendent morning sun.

The Court pointed out the continuity of business doctrine: five years before and five after. The activity might be a-gleaming, but it was not fresh-born.

Rogerson tried a long shot: he had not materially participated in that winner prior to the reorganization. The winner had just been caught up in the tide by his tax preparers. How they shrouded their inscrutable dark arts from prying eyes! Oh, if he could do it over again ….

The Court made short work of that argument: by your hand, sir, not mine. If Rogerson wanted a different result, he should have done - and reported - things differently.

Our case this time was Rogerson v Commissioner, TC Memo 2022-49.

Can You Really Be Working If You Work Remotely?

Have you ever thought of working remotely?

Whether it is possible of course depends on what one does. It is unlikely a nurse could pull it off, but could an experienced tax CPA…?  I admit there have been moments over the years when I would have appreciated the flexibility, especially with out-of-state family.

I am looking at a case where someone pulled it off.

Fred lived in Chicago. He sold his company for tens of millions of dollars.

COMMENT: I probably would pull the (at least semi-) retirement trigger right there.

He used some of the proceeds to start a money-lending business. He was capitalizing on all the contacts he had made during the years he owned the previous company. He kept an office downtown at Archer Avenue and Canal Street, and he kept two employees on payroll.

Fred called all the shots: when to make loans, how to handle defaulted loans. He kept over 40 loans outstanding for the years under discussion.

Chicago has winters. Fred and his wife spent 60% of the year in Florida. Fred was no one’s fool.

But Fred racked up some big losses. The IRS came a-looking, and they wanted the following:

                   Year                          Tax

                   2009                     $336,666

                   2011                     $  90,699

                   2012                     $109,355

The IRS said that Fred was not materially participating in the business.

What sets this up are the passive activity rules that entered the Code in 1986. The IRS had been chasing tax-shelter and related activities for years. The effort introduced levels of incoherence into the tax Code (Section 465 at risk rules, Section 704(b) economic substance rules), but in 1986 Congress changed the playing field. One was to analyze an owner’s involvement in the business. If involvement was substantial, then one set of rules would apply. If involvement was not substantial, the another set of rules would.

The term for substantial was “material participation.”

And the key to the dichotomy was the handling of losses. After all, if the business was profitable, then the IRS was getting its vig whether there was material participation or not.

But if there were losses….

And the overall concept is that non-material participation losses would only be allowed to the extent one had non-material participation income. If one went net negative, then the net negative would be suspended and carryover to next year, to again await non-material participation income.

In truth, it has worked relatively well in addressing tax-shelter and related activities. It might in fact one argued that it has worked too well, sometimes pulling non-shelter activities into its wake.

The IRS argued that Fred was not materially participating in 2009, 2011 and 2012. I presume he made money in 2010.

Well, that would keep Fred from using the net losses in those respective years. The losses would suspend and carryover to the next year, and then the next.

Problem: Sounds to me like Fred is a one-man gang. He kept two employees in Chicago, but one was an accountant and the other the secretary.

The Tax Court observed that Fred worked at the office a little less than 6 hours per day while in Chicago. When in Florida he would call, fax, e-mail or whatever was required. The Court estimated he worked 460 hours in Chicago and 240 hours in Florida. I tally 700 hours between the two.

The IRS said that wasn’t enough.

Initially I presumed that Barney Fife was working this case for the IRS, as the answer seemed self-evident to me. Then I noticed that the IRS was using a relatively-unused Regulation in its challenge:

          Reg § 1.469-5T. Material participation (temporary).

(a)  (7)  Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The common rules under this Regulation are the 500 hours test of (a)(1), the substantially-all-the-activity test of (a)(2) and 100-hours-and-not-less-than-anyone-else test of (a)(3). There are only so many cases under (a)(7).

Still, it was a bad call, IRS. There was never any question that Fred was the business, and the business was Fred. If Fred was not materially participating, then no one was. The business ran itself without human intervention. When looked at in such light, the absurdity of the IRS position becomes evident.

Our case this time was Barbara, TC Memo 2019-50.

Is There A Tax Difference Between A Company And An Activity?

Some tax cases are just fun to read.

Our story takes place in south Florida.  

Dad started a business many years ago. It did well, and Dad in turn started three businesses for his children. He structured each business so that one sibling owned 60% and the remaining two siblings owned the balance. He gave each child (two daughters and a son) a controlling interest in their own business, with the remaining siblings owning a (non-controlling) interest.

All these businesses were somehow tied-in to real estate, whether by selling lumber, providing mortgages, payroll services or other activities.

Our protagonist (Jose Antonio Lamas) owned a company called Adrimar.

However the company we are interested is called Shoma, and it is (majority) owned by Jose’s sister and her husband (Masoud Shojaee).

Shoma formed an LLC (Greens at Doral) pursuant to a condominium development. The two companies were closely intertwined. Greens had the same ownership as Shoma, operated out of the same office, used the same employees and so on. Shoma intended to liquidate Greens once the project was done, which is the standard structure for these projects.

 

Shoma got itself into financial straits. Jose was called in to help turn Shoma around.

The soap opera is in the details of how Shoma got itself into difficulties. Turns out that Mr. Shojaee was using Shoma to guarantee loans for a non-family company he owned. He made a pledge to the University of Miami for $1.5 million, in return for which they were going to name a building after him. That is swell, except that he had no intention of using his own money. Instead he used Shoma money to fund the donation. He developed Shoma land – and we have a feel for his ethics at this point – but decided to run the development (and profits) through his own company.

Somewhere in here Jose and his sister had enough and in 2008 sued Mr. Shojaee.

Knock me over with a feather.

Shoma must have been losing crazy-level money, as Jose filed for a tax refund of over $5 million.

Here is an easy quiz: what happens when you file a tax refund of over $5 million with the IRS?

The IRS audits you, that’s what.

What is there to audit, you ask? The “real” audit would be on the business books, not Jose’s personal return, right?

Not so fast.

You see, if Jose did not “materially participate” in the business, then the business would be “passive” to him. He would not be able to offset his other income with that big “passive” loss. The loss would have to wait for passive income to someday soak it up.

Jose needed to provide time records to show that he worked over 500 hours, which is the gold-plated standard of showing “material participation” to the IRS.

Problem: he was not accustomed to working someplace where he kept time records. He didn’t have any. He had to go to plan B, which means evidencing his times through other means, such as by showing regular appointments and obtaining the testimony of other people.

He talked to Tania Martin, who was CFO for Shoma. She testified that she did not see Jose at the office, except maybe one time. There was a problem with her testimony, though. You see she worked remotely from North Carolina.

Francisco Silva was in-house counsel for Shoma. He testified that that Mr. Lamas would walk past his office in the morning and say “hi.” Other than that, he didn’t know “what, if anything, he was doing. I just don’t know.”

Then there was a stream of other people who worked regularly and extensively with Jose, including obtaining financing, soliciting investors, visiting jobsites and so on.

Alex Penelas, for example, was a former Miami-Date County mayor who testified that it was “more effective” to talk with Jose than Mr. Shojaee.

Jose had provided a letter to the IRS from his employer – Shoma - and signed by Mr. Shojaee, stating that he was a full-time employee. It appears that after brother and sister decided to sue, Mr. Shojaee sent a corrected letter to the IRS wherein he stated:

"Recently Shoma Development learned that the IRS requires active participation and 500 hours of work to qualify” and that “Jose Antonio Lamas had no direct nor indirect involvement with Shoma.”

Mr. Shojaee did request the IRS to keep this letter quiet, of course, lest it cause him family trouble. He is clearly all about the family.

The case finally gets to Court, which decides that Jose did work over 500 hours and that Mr. Shojaee was a creep.

But… there is one more thing.

You see, Jose worked for Shoma (an S corporation), not Greens (an LLC), and Greens was a substantial part of the loss.

Which brings us to the tax issue herein: can Shoma and Greens be combined, so that by showing material participation in Shoma, Jose also showed material participation in Greens?

The concept at play is whether the activities comprise an “appropriate economic unit,” a concept introduced to the tax Code as part of the passive loss rules in 1986. An example would be four related companies, each of which owns theaters: one east, one south, one north and one west. The common activity is owning theaters, and if there are enough other similarities then one could determine that the four companies comprise one economic activity. How is this important? If one shows a big loss while the other three show profits, for example. If they are one economic unit, the income and loss would automatically offset without having to employ a lot of tax planning.

So the Tax Court reviewed the rules in Regulation 1.469-4(c) for evaluating an appropriate economic unit:

(1)  similarities and differences in types of business

(2)  the extent of common control

(3)  the extent of common ownership

(4)  geographical location, and

(5)  other interdependencies

It found that there was sufficient overlap between Shoma and Greens that Jose was materially participating in both, and that he was entitled to his tax refund.

And I suspect that Mr. Shojaee is no longer invited to family functions.

How Much Would A Worker Have To Work Before The IRS Believes They Were Really Working?

Can you own and work at a company but have the IRS consider it to be a “passive activity” for tax purposes?

The question seems odd to me, as I have never worked somewhere where I wasn’t unquestionably “materially participating.” There isn’t much choice, given what I do. I would like to someday, though. It’s on my bucket list.

What do these terms mean?

The terms entered the tax Code in 1986, and they were a (mostly successful) effort to battle tax shelters. To trigger the issue one had to have invested in a business activity, and one’s share (whether large or small) wound up on one’s personal tax return. This means – generally – that one is invested in a partnership, LLC or S corporation. One receives a Schedule K-1 for his/her ownership interest, and those numbers are included with one’s other income (a W-2, for example) on the personal return.

Make those numbers negative and you understand the mechanics of a tax shelter.

Congress said that one had to separate those activities into two buckets. The first was a “material participation” bucket, for activities where you actually worked. Those numbers went on your tax return whether they were positive or negative. Congress saw little risk of a tax shelter if one actually worked at the place.

The second was the “passive activity” bucket. Congress put stringent limits on the ability to use negative numbers from this bucket to offset other income. Congress wasn’t going to allow negative numbers from the passive activity bucket to offset positive numbers from one’s actual job.

You can anticipate that the definition of “material participation” was critical.

There are seven tests to qualify as material participation. They are found in Reg. 1.469-5T and are as follows:

·  The taxpayer works 500 hours or more during the year in the activity.

·  The taxpayer does substantially all the work in the activity.

·  The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.

·  The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.

·  The taxpayer materially participated in the activity in any 5 of the prior 10 years.

·  The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.

·  Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

The key one is the first – the 500 hour test. That is the workhorse, and the one practitioners prefer to use. The 5-out-of-10 years test allows one to retire, as does the any-3-prior- years test. The SPA test is goofy, and should it be a one-person business, then the substantially-all-the-work test bypasses any reference to hours worked.

Then there is the last one – “facts and circumstances.” This is a fallback, in case one cannot shoehorn into one of the other tests. Tax practice being unpredictable, one would have expected a substantial body of precedence on what comprises “facts and circumstances.” We have had more than 25 years, after all. One would have been wrong, as the IRS prefers to proceed as though this test did not exist.

Now we have the Wade case.

Charles Wade owned stock in two corporations: Thermoplastic Services, Inc. (TSI) and Paragon Plastic Sheeting, Inc. (Paragon). He started these companies in 1980 to address the environmental impact of plastic waste materials. TSI acquired waste from chemical companies and converted it into useable products. Paragon bought raw materials from TSI and used them to make building and construction materials. Sounds green.

In 1994 his son (Ashley) came on board, and eventually wound up managing the companies.

This freed up his dad. Wade could be more involved with the customer relationships and less with the day-to-day stuff. This gave dad (and mom) a chance to move to Florida. He could still call and schmooze customers from Florida. I too would like the opportunity to work from Florida, especially as we get closer to winter.

Fast forward another fourteen years, and in 2008 the companies were struggling for their financial lives. Dad decided to step it up. He did the following:

·        Made 273 phone calls to the plant in 2008

·        Travelled to the plant three times to motivate and reassure employees that the companies would continue

·        Intensified his R&D efforts, resulting in

o   A new technique for fireproofing polyethylene partitions

o   A new method for treating plastics to destroy common viruses and bacteria on contact

·        Guaranteed a new line of credit

Wow! This man did everything short of stepping into a phone booth and coming out as Superman.

But 2008 was a tough year. His losses from the companies (including one other, which need not concern us here) was $3.8 million.

This created a net operating loss (NOL) on his personal return. Truthfully, a negative $3.8 million would create an NOL for pretty much all of us. He did what we would do: he carried back the NOL as allowed, which is to the prior two years. Any amount not used there can be carried forward 20 years. Why would he do that?

To obtain a refund of the taxes he paid in 2006 and 2007, that’s why.

Of course, the IRS did not like this at all. They argued that TSI and Paragon were passive activities to Wade, and there is no NOL from passive losses. In fact, there is no “loss” from passive losses, as the best passive activities can do (generally) is get to zero.

And both parties are bound for Tax Court.

The Court looks and notes that Wade has a couple of arguments. The first is that he spent more than 500 hours working at TSI and Paragon.

Now, this can be messy to prove, unless one is actually in the building every day. Time sheets or records would be great. This is an area where keeping good records is key.

The Court continued. Wade also argued that he worked on a “regular, continuous and substantial basis” in 2008. This is the last test from Reg. 1.469-5T, and is the one the IRS likes to ignore.

The Court decided it liked that one. Maybe it did not want to go through time records, which is understandable. 

It looked at the facts and said “duh!” to the IRS. Wade easily spent more than 100 hours just calling the plant (100 hours is the minimum under the facts-and-circumstances test). He developed new technology, called every day, visited the facilities several times, secured financing. Good grief IRS, what more did you want the guy to do?

The Court decided for Wade, noting:

TSI and Paragon are complex businesses that Mr. Wade built from the ground up and in which he continued to play a vital role. He was not merely a detached investor, as has often been the case when we have found that a taxpayer did not materially participate.”

So Wade won. The IRS would have to issue him refunds from his NOL carryback.

But the IRS made their point: they remained skeptical of anyone who wants to prove material participation by means of facts and circumstances.

Of course, a $3.8 million dollar NOL carryback undoubtedly did a lot to spotlight that facts-and-circumstances claim.