His tenants’ inability to deal with taking out the trash appears to have been a key factor in allowing the taxpayer in Franco v. Commissioner, TC Summary Opinion 2018-9 to qualify as a real estate professional.
Jose Franco is a licensed architect and he ran a small architectural business for the year in question. Normally this would create a significant issue for Mr. Franco to be classified as a real estate professional, since Mr. Franco was not contending that his architectural work was a real property trade or business.
The problem that normally presents in such cases is that the taxpayer is unable to meet the requirement, found in IRC §469(c)(7)(B)(i) that “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…” Mr. Franco was not attempting to argue that the court should allow him to treat has architectural business as one that was in the business of “construction” or any of the other categories of real property businesses found at IRC §469(c)(7)(C).
But Mr. Franco was not working full time as an architect. His records showed he had performed 109 hours of services for Wells Fargo’s trust department and another 540 hours doing work for construction consulting company. Thus, he had 649 hours in the non-real property business.
So that meant that Mr. Franco merely needed to satisfy the second test under IRC §469(c)(7)(B)(ii). Under that test he had to show he had spent more than 750 hours in services for real property trades and businesses in which he materially participated. Rentals are listed as a real property trade or business under IRC §469(c)(7)(C) and the IRS did not dispute that Mr. Franco was covered by an election under IRC §469(c)(7)(A) to treat all of his rental activities as one.
Under Reg. §1.469-5T(a)(1) if a taxpayer has more than 500 hours of participation in an activity, that will meet the requirement to be treated as materially participating. Thus, if Mr. Franco could show he had 750 hours of participation in his rentals he would automatically be treated as materially participating in the rental. So, the only question is whether Mr. Franco had spent more than 750 hours in the activities.
At first glance it doesn’t look good—he owned only two rental properties, though one of them was a four-plex. But Mr. Franco had records to show what he had done regarding these properties and, just as important, his records and testimony were found to be credible.
Of course, 750 hours is still quite a few hours for just these two properties, so to be credible there had to be a plausible reason why Mr. Franco had spent so many hours dealing with these properties.
The Court noted that a number of factors combined to push Mr. Franco’s hours over the 750-hour threshold for 2013, not the least of which being the fact that his tenants weren’t very good about taking care of the details of the weekly trash pickup.
As the Court describes matters:
Mr. Franco managed the rental properties during the year in issue. Because his tenants were not attentive to trash disposal matters, Mr. Franco made weekly trips to the properties to ensure that trash bins were set out for collection, cleaned if necessary, and returned to their storage locations. He also performed minor repairs at the properties, coordinated more substantial repairs with a handyman, communicated with the tenants and collected and deposited rent, maintained insurance policies, purchased materials for the properties as needed, paid bills, and kept books and records of his expenses for tax accounting purposes.
Two of the four tenants at Edgehill Drive moved out in 2013. As a result, Mr. Franco spent additional time coordinating with them as they vacated the apartments, performed extra repair and maintenance work to ready the apartments for new tenants, placed advertisements listing the apartments for rent, and worked with new tenants as they signed leases and moved into the apartments.
Mr. Franco was late paying property taxes and insurance premiums on both rental properties during 2013. Consequently, he was obliged to spend time negotiating a property tax installment payment plan and had to work with his mortgage lender to eliminate redundant insurance coverage on the properties.
He presented the Court with an activity log that showed he had spent 765 and 372 in activities related to each of the rentals. And this log was corroborated by other evidence that Mr. Franco produced (receipts, emails and other records).
The real take-away from this case is to carefully note details about Mr. Franco’s rental records:
- The reasons for having what might appear to be excessive hours were well documented, making it plausible that he could have qualified;
- He had activity logs that were real logs—not just rough “ballpark estimates” of work he had done; and
- Those logs agreed with outside evidence strongly suggesting that Mr. Franco had been performing the services in question at the times in his log.
The history of cases in this area makes it clear that the key issue will most often come down to whether a taxpayer can produce records of the sort that Mr. Franco did.