Court Find Taxpayer's Log of Participation Time for Rentals Inflated by 150 Hours, Did Not Meet Tests for Real Estate Professional

In what has happened quite often over the past few years, the Tax Court found in the case of Hairston v. Commissioner, TC Memo 2019-104[1] that the taxpayers had failed to show that either was a real estate professional.  Thus, losses of just under $55,000 over three years were treated as passive activity losses.

IRC §469(c)(2) provides a blanket rule that a rental activity is automatically treated as a passive activity.  However, IRC §469(c)(7) was added to the law to grant relief from this automatic treatment to individuals who are real estate professionals.

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Taxpayer Found to Materially Participate in Activity Based on Facts and Circumstances

The IRS argued that the taxpayer in Barbara v. Commissioner, TC Memo 2019-50 did not materially participate in the trade or business of lending money, leading to a proposed assessment of tax of over $536,000 along with a 20% substantial underpayment penalty under §6662(a).  But the Tax Court did not agree with the IRS’s view in this case.

After selling his trucking business, Fred Barbara used the money to start a money lending business.  The office of the money lending business was in Chicago, IL.  The business employed two full time employees:  an accountant and a secretary.

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Tax Court Rejects Taxpayer's Reconstruction of Real Estate Hours

When taxpayers attempt to reconstruct their hours in activities from memory when they receive an exam notice to sustain their burden of proving qualification as a real estate professional, the result is rarely a successful defense of that assertion.  Many of the problems are illustrated in the case of Pourmirzaie v. Commissioner, TC Memo 2018-26.

The taxpayers did have several rental properties.  The Court listed them as follows:

  • A four-unit residential property in San Jose, California (San Jose property);
  • A single-family condominium in San Diego, California, in which petitioners owned a partial interest (San Diego property);
  • A single-family residence in Tucson, Arizona (Tucson property);
  • A single-family condominium in Bremerton, Washington (Bremerton property); and
  • A single-family residence in Discovery Bay, California (Discovery Bay property).

The taxpayers did not maintain any sort of log or calendar of the work performed on these properties during the years in question.  Nevertheless, on their tax returns for the year in question they took the position that Mrs. Pourmirzaie was a real estate professional. 

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Tenants' Inability to Handle Trash Matters Helped Architect Qualify as Real Estate Professional

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. 

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IRS Does Not Agree S Corporation Restricted Stock Ownership Counts for Real Estate Professional

In a case discussed here in 2015 (Restricted Stock Interest Still Found to Constitute Ownership Interest for Qualifying as Real Estate Professional) an Arkansas U.S. District Court held that a taxpayer who held restricted stock that constituted greater than 5% of the stock of the corporation could count hours worked in that entity towards qualifying as a real estate professional.

As is discussed in the original article, so long as no Section 83(b) election is filed by the taxpayer, the restricted stock is treated for S corporation purposes as "not issued" and thus does not create second class of stock issues.  The IRS had argued that same provision meant that the stock had to be ignored for purposes of the 5% stock ownership rule for counting as real estate professional hours time spent working as an employee for the S corporation.  The court did not agree with the IRS and treated the individual as a real estate professional.

Now the IRS has announced the agency will not follow the result in this case in Action on Decision 2017-07.  In a footnote the agency described the specific issues the agency was disagreeing with.

Nonacquiescence relating to the holdings that: 1) mere possession of a stock certificate, disregarding other conditions, restrictions or limitations on the possessor’s rights regarding the stock, constitutes ownership for purposes of § 469(c)(7)(D)(ii); and 2) work performed by the taxpayer in a rental real estate activity for purposes of § 469(c)(7)(A) may also constitute work performed by the taxpayer in non-rental business activities of the taxpayer for other purposes of § 469.

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Taxpayer's Claim of Working Nearly 13 Hours Each Day Found Not Credible, Denied Real Estate Professional Status

While it is not impossible to qualify as a real estate professional under IRC §469(c)(7) if the taxpayer has a non-real estate full time job, it certainly is going to be difficult.  The limited number of hours in the year created a credibility problem for the taxpayer in Penley v. Commissioner, TC Memo 2017‑65, causing the Tax Court to find he had proven he qualified as a real estate professional.

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Dentist Establishes He Was a Real Estate Professional

The Tax Court accepted the taxpayer’s position that he was a real estate professional in the case of Zarrinnegar, et al v. Commissioner, TC Memo 2017-34.  And Dr. Zarrinnegar prevailed in this case despite working in his own dental practice with his spouse, Dr. Dini.

To be classified as a real estate professional a taxpayer must meet two tests.  First, the taxpayer must have over 750 hours of services in real property trade or businesses in which he actively participates and more than one-half of the personal services performed in trades or businesses in which the taxpayer participates must be in real property trades or businesses.  [IRC §469(c)(7)]

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Surgeon's Interest in Surgical Center Generated Passive Income and Taxpayer Did Not Need to Group With Medical Practice

A Technical Advice Memorandum issued by the IRS after the audit ended was cited by the Tax Court to the IRS’s detriment in the case of Hardy v. Commissioner, TC Memo 2017-16. The issue involved was whether a surgeon materially participated in a surgical center in which he owned a minority interest—with the IRS at court pushing for finding that the surgeon had to combine that activity with his regular medical practice for purpose of determining material participation.

The surgeon this case is a plastic surgeon, specializing in pediatric reconstructive surgery, who operated on patients in his office and in some local hospitals.  The surgery must take place outside of his office if the surgery requires general anesthesia.  The doctor was finding that at times he was having difficulty obtaining space at the local hospitals for his procedures due to a limited number of available operating rooms.

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Real Estate Professional's Rentals Do Not Automatically Escape Passive Loss Limitations

Delores Gragg in 2006 and 2007 was a licensed real estate agent who had sufficient hours in the real estate activity to be treated as a real estate professional under IRC §469(c)(7).  Based on that qualification alone, she and her husband took the position that she should be allowed to be treated as materially participating in the rentals and thus all losses be allowed in full on their returns without regard to Section 469.

However the Ninth Circuit Court of Appeals, considering this “automatic material participation” argument for the first time, rejected this view in the case of Gragg v. United States, Case No. 14-16053, CA9 affirming a decision of the U.S. District Court of Northern California.

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Restricted Stock Interest Still Found to Constitute Ownership Interest for Qualifying as Real Estate Professional

A recent Arkansas U.S. District Court case involved the court resolving a number of not often raised in court questions regarding the interaction of the passive activity rules, the real estate professional classification, S corporations and stock provided to an employee that was subject to restrictions triggering treatment under IRC §83(b).  The case in question is the case of Stanley v. United States, 116 AFTR2d ¶2015-5419, Case No. 5:14-CV-05236, U.S.D.C. Western District of Arkansas.

The issues arose regarding Mr. and Mrs. Stanley's claimed deductions for losses on Schedule E that arose from real estate related activities.  Mr. Stanley took the position that he qualified as a real estate professional and that all of the various items reported on Schedule E were properly classified as a single activity under the passive activity rules.

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Taxpayers Present Evidence Found to Show They Met the "More Than Others" Test for Material Participation

In the case of Kline v. Commissioner, TC Memo 2015-144 the question before the Tax Court was whether the taxpayers in this case met the requirements to be treated as materially participating in the activity.

Specifically the question was whether they had met the requirements of Reg. §1.469‑5T(a)(3) for the “more than others” test for material participation. 

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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.

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Taxpayer Materially Participated in Activity, Investor and Work Not Customarily Done by Owner Exceptions Did Not Apply

The IRS has lost again on the question of material participation for a taxpayer helping the family business deal with the financial crisis of 2008.  In the case of Lamas v. Commissioner, TC Memo 2015-59, the issue was whether the taxpayer had materially participated in businesses in 2008 where the taxpayer’s share of losses generated multi-million refunds from a net operating loss carryback.

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