A taxpayer was able to persuade the Tax Court, if not the IRS, that he was a real estate professional who materially participated in the rental of a triplex next door to his home in the case of Smith v. Commissioner, T.C. Summary Opinion 2014-112.
Generally rental activities are automatically treated as passive activities [IRC §469(c)(2)]. This automatic classification of a rental as passive does not apply if a taxpayer is a real estate professional. [IRC §469(c)(7)] A real estate professional is defined as an individual who spend time in real property trades and businesses in which he materially participates than in all other personal service activities combined and spends more than 750 hours in such real property trades and businesses. [IRC §469(c)(7)]
In that case, any rental activity in which the taxpayer is able to demonstrate material participation will not be subjected to the passive loss limits. [IRC §469(a) and (b)]
The taxpayer in question was a 63-year-old disabled veteran. The Veteran’s Administration had determined the taxpayer was 60% disabled and is paying the taxpayer monthly disability assistance. During his service in the U.S. Marine Corps he sustained injuries that left his right arm 50% disabled and his feet 30% disabled. The foot disability required the taxpayer to wear orthopedic shoes. He in need of knee replacement surgery and has difficulty seeing.
The taxpayer did not keep detailed contemporaneous records of his work on the rentals, but did testify regarding his activities. The triplex had six recycling bins and, being located on the route to a nearby recycling center, tended to attract homeless individuals who rummaged through the bins and garbage, and often slept on the property.
The taxpayer did not employ anyone to assist him with the triplex, rather handling the administrative tasks, routine maintenance and repairs himself. The taxpayer was available 24 hours a day to handle various tenant issues, ranging from requests for repairs to dealing with tenants that locked themselves out of their unit. Each tenant paid their rent on a different day of the month and the taxpayer would take each check to the bank when he received it, then return home and enter the rent receipt into his computerized accounting system.
He also spent time each month generating notices and writing correspondence with tenants. In one of the years under challenge the taxpayer was involved in an unlawful detainer action against one of his tenants.
The taxpayer followed a set routine in maintaining the properties, never taking a vacation during the years in question. He would walk the property each morning and inspect the property for trash left behind by the homeless. On Tuesdays and Fridays he handled landscaping issues and cleaned the outside of the buildings. At times this also required him to rake leaves from the walnut trees on the property, as well as deal with fallen walnuts and empty walnut shells left behind by squirrels. Wednesday evening he would take each of the 64 gallon recycling bins to the curb and he would return each from the curb each Thursday morning.
When a repair was needed the tenant would contact the taxpayer. He would then arrange for a repairman, who would report to the taxpayer when he arrived on site. The taxpayer would then inspect the work of the repairman when he finished or confirm with the tenant that the matter had been satisfactorily resolved.
The taxpayer evicted one tenant who had left his unit in poor shape. The tenant had been a smoker and had left the unit with brown residue over the walls. The taxpayer cleaned those walls and also arranged for the replacement of the carpet by researching carpet, preparing the unit to have the old carpet removed and scheduling and overseeing the carpet removal and installation.
The IRS complained that the taxpayer was not a real estate professional. The Tax Court noted that since Mr. Smith was disabled and had no other occupation, the Court did not need to worry about the requirement that Mr. Smith show he had spent more time in real estate activities than in others during the year—the real estate activities amounted to 100% of his work during the year.
The Court also found the taxpayer had materially participated in the rental activities. The court found he met the “substantially all” test. While had employed some repairmen, their work had been so minor compared to Mr. Smith’s regular activities that they did not cause him to fail the substantially all test.
The IRS complained that, regardless of those facts, Mr. Smith did not show he spent 750 hours in activities related to the rental. As was noted, Mr. Smith did not have detailed logs of his time. While it was clear he had done the various things mentioned (his routine helped here), the IRS argued that the estimate of time to complete the various tasks was well beyond the time such tasks should have taken.
The Tax Court agreed that, in most cases, that would be true. But in this case the fact that Mr. Smith was disabled meant that the activities would take him significantly longer than it would take an average, non-disabled person to accomplish the same tasks. The Court then worked up its estimate of the time it determined it likely took Mr. Smith to accomplish the various tasks given his disabilities and found this amounted to more than 750 hours. Thus, the Court found, he was a real estate professional who materially participated in the triplex rental, meaning the losses were not subjected to the passive loss rules of §469.