Tax Court Accepts Taxpayer's Reconstruction of Travel Hours to Push Over 750 Hour Real Estate Professional Limit

Taxpayers who have tried to reconstruct log showing they met the qualified real estate professional requirements have generally fared poorly in Tax Court.  But in the case of Leyh and O’Neill v. Commissioner, TC Summary Opinion 2015-27 the Tax Court accepted the reconstructed records—but there are key facts that make this case different from the earlier taxpayer failures.

Ellen O’Neill was involved in handling the 12 rentals the couple owned, 11 of which were single-family residences and one of which was a condominium unit.  She performed some of the repairs and most of the maintenance on the property, advertising for, interviewing and vetting tenants, handled the paperwork, performed the bookkeeping and did research for properties to acquire.  In the year in question she did extensive research on potential rental properties to acquire in Florida.  Ellen did not perform other business activities during the year, thus 100% of her hours for business were related to the rentals.

Their rental properties were located in Austin, Texas.  The taxpayers lived on a ranch approximately 26 to 30 miles from the rental properties.  Driving to the properties took from 42 to 55 minutes depending on the route that was taken and the traffic that was encountered on the trip.

Ellen claimed to qualify as a real estate professional.  They had been examined in earlier years on the issue of being a real estate professional, so Ellen was aware of the base requirement of showing 750 hours of material participation during the tax year to qualify to claim the losses.

Ellen did keep a log of her activities and presented that log during the exam.  However, for whatever reason, Ellen’s log did not include the time spent traveling from their ranch to the rental properties.  When the hours in the log were totaled they added up to 632.5 hours which was 127.5 hours short of the 750 hour minimum.

The agent, therefore, took the positon that Ellen was not a real estate professional.  As such, her rental activity was, by statute, a passive activity and the $69,531 loss was reclassified as a passive loss, resulting in an increase in tax due.

Ellen went back and revised the log to reflect her travel time and now the log totaled 846 hours, now being 96 hours more than the 750 hour minimum.  However the agent refused to accept those hours.

The IRS’s only objection was that Ellen did not provide sufficient documentation that she met the 750 hour minimum.  The IRS accepted the hours in the original log, but argued that she had not provided sufficient evidence to support any additional hours.  In particular the IRS felt that Ellen had not shown that the travel time wasn’t already incorporated in the times listed in the original log.

The Tax Court noted that the original log did clearly document what Ellen had done, as well as where she had undertaken each activity.  At trial Ellen was able to carefully describe what she had done on the various occasions with only minor discrepancies uncovered during extension IRS questioning of her at trial.

Ellen, in adding hours to the revised log, had noted the location of each activity.  For each day that the activity took place in Austin, she added 1.5 hours for travel to and from her home at the ranch.

The IRS noted what was mentioned at the beginning of this article—the Tax Court had regularly denied taxpayers credit for “reconstructed” records in an attempt to prove qualification, citing Bailey v. Commissioner, T.C. Memo 2011-296, Speer v. Commissioner, T.C. Memo. 1996-323 and Goshorn v. Commissioner, T.C. Memo. 1993-578.

However the Tax Court noted its objections in those cases were to “ballpark estimates” that had been put together by taxpayers.  The regulations provide the following, in the view of the Court, somewhat ambiguous requirements for documentation:

The extent of an individual’s participation in an activity may be established by any reasonable means.  Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries. [Reg. §1.469-5T(f)(4)]

Noting those requirements, the Court pointed out that the cases the IRS was pointing to:

“did not involve a detailed contemporaneous log such as the one petitioner maintained.  Petitioner provided day-by-day explanations of the specific rental real estate activity in her log.  Further, from the log it was easy to identify days when the activity took place in Austin.  Finally, petitioner has shown that the travel time was not included in the original log.  Petitioner’s log and her revised log showing the travel time are well within the guidelines of section 1.469-5T(f)(4), Temporary Income Tax Regs., supra.

Thus the Court found that Ellen was a real estate professional and the loss in question was not a passive loss.

While the taxpayer got a win out of this one, note that it appears that no one noticed before the exam got underway that the log did not total more than 750 hours, despite the fact that the taxpayer was aware of that requirement.  In fact, it appears the issue may very well have been first noticed by the IRS agent who added up the hours. 

Clearly advisers preparing for an examination (especially in an area where the taxpayer has already been examined) need to take a critical look at the records to be submitted to the IRS before they are actually submitted to identify areas of likely IRS attack.  Presumably had such a review taken place before the logs were submitted the taxpayer could have submitted the reconstructed time travel at the same time as the main log, potentially defusing the issue.

It is human nature (and double that for those in tax practice, at least based on the author’s experience) to want to continue to defend a position once a person goes on the record taking a position, so it’s not surprising that once the agent discovered the failure to met the 750 hour he/she now felt the issue had been conclusively determined—which it would have had those hours been correct.  It would be much easier for an agent to accept those extra hours before “going on the record” that the taxpayer failed to qualify.