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.

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.

Rental of U.S. Real Estate by a Nonresident

I was speaking with someone from overseas about buying real estate around here and renting it out. This person is a green card holder, so their tax considerations in owing rental real estate would be the same as yours or mine.

But what if they were not a green card holder?

Different set of rules. We are talking about the U.S. taxation of a nonresident alien. A nonresident alien does not have a green card or spend enough time in the U.S. to be considered a resident.

There are two ways to handle a nonresident alien’s reporting of U.S. rental real estate.

Let’s call the first one the “default” rule. This type of income is referred to as “fixed, determinable, annual or periodic” (FDAP) and carries a 30% tax rate on the gross amount of income. Examples of FDAP are interest, dividends, annuities, royalties and rents. 

Let’s use some numbers to make this concrete:

                        Rent received                                                24,000

                        Property management                                    2,400

                        Real estate taxes                                            6,000

                        Insurance                                                        1,600

                        Depreciation                                                   9,000

                        Net profit                                                        5,000

Oh, the property manager will have to withhold the 30% upfront. The manager has to, as the tax code requires the manager to pay the 30% from his/her own funds if he/she does not withhold it from you.

Under the default rule the property manager will withhold 30% of your rental income, or $7,200, and forward it to Treasury. At the end of the year the manager will send you a Form 1042-S reporting the withholding. The good news is that you do not have to file further taxes. The bad news is that it cost you 30%.

NOTE:  The 30% is not cast in stone. It can be overridden by treaty.

The second way is to make an election, so let’s call it the “election” rule. The idea here is that you have a trade or business in the United States (you do, sort of, as a landlord), and you are going to elect to have the rental property “effectively connected” to your business. The principal tax difference is that you will owe tax using graduated tax rates on your net rental income. To phrase it another way, “effectively connected income” (ECI) of a foreign person is taxed like the income of a U.S. person.

The first thing you do is file a form (Form W-8ECI) with the property manager so the manager does not have to withhold 30% from you.

The second thing you have to do is file a tax return (Form 1040NR) at the end of the year. You have to include an election in the return alerting the IRS what you are up to. You will pay tax on $5,000, which is big improvement over paying tax on $24,000. Technically, you would be paying tax on less than $5,000, as you also get a personal exemption, but you get the idea. You also have graduated tax rates – not a flat 30% like under the default rule.

By the way, if you came into our offices using the default rule, we would likely encourage you to file a return anyway under the election rule. Why? To get back some of your 30% withholding, that’s why. The government would have gotten $7,200 from you. That was more than your profit before giving the government anything! Then we would have you fill out the paperwork to have the property manager stop withholding on your rent checks.

Appeal of Destino Properties, LLC

Here is a June addition to our ongoing discussion of questionable state tax laws.

This one takes us to California.

Destino Properties LLC (“LLC”) was organized in Nevada. It had one asset: a single family home in Nevada. The LLC had four members, three of which lived in California. One of the California members received the rental checks and deposited them to a California bank account. The LLC argued that the majority of its management activities, to the extent there were any, took place outside California.

Let’s add one more fact. California charges an $800 annual fee for LLCs and disregarded entities doing business or registered in the state. The LLC was not registered in California.

Question: does Destino have to pay the $800 fee to California?

The Franchise Tax Board (FTB) contended that Destino was doing business in California because actions by members are attributable to the LLC. Therefore, if the member performed activities in California, those activities could be imputed as LLC activities.

Think about this for a second. The one activity of the LLC was to rent property. It did this in Nevada. The title was in Nevada. The insurance was in Nevada. The real estate taxes were in Nevada. Last time anyone looked, Nevada was not a county of California. Did the managerial activities of the LLC (three-fourths of which were in California) outweigh THE SOLE operational activity of the LLC (which was ALL in Nevada)? What if the LLC was a plastic fabricator with a workforce of 200 employees? Would it still be pulled in by California? At which point would the operational activities of the LLC outweigh the managerial activities of its members?

California reasoned that receiving rental checks, authorizing repairs and hiring a California tax preparer all constituted “doing business” in California. Here is tax planning: hire K&C as your CPAs. We are in Ohio, which is not California. We might recommend that the rental checks also come here, and we could deposit them on your behalf. You could choose an Ohio or a Kentucky bank, as Kentucky is just across the river. That would be two less activities for California to claim.

What is going on, of course, is that California was going find nexus, no matter what.