You buy real estate and hold it for rental income. The real estate produces losses. The losses are increased by various items, such as depreciation deductions, interest expense deductions, etc.
You spend the year working on your rental properties and at your part-time job.
Can you offset the income from your part-time job with your rental losses?
The answer is maybe. You have to carefully study the passive activity loss rules to see. The Franco v. Commissioner, T.C. Summary Opinion 2018-9 provides an opportunity to consider these rules.
Facts & Procedural History
The taxpayers owned two rental properties. The rental properties were single family residences. The rental properties generated a $67 thousand dollar loss in 2013.
The taxpayer-husband also worked part-time as an architect. He earned $85 thousand from this work in 2013. The income was reported on Schedule C, Profit or Loss from Business (Sole Proprietorship).
The taxpayers netted the real estate loss and self-employed income on their income tax return for 2013.
The IRS audited the tax return and disallowed the rental loss. The taxpayer filed a petition in U.S. Tax Court to dispute the IRS’s determination.
Passive Activity Losses for Rental Real Estate
The passive activity loss rules can prevent taxpayers from being able to deduct losses from passive activities. These rules treat rental real estate as a passive activity. That is the general rule.
There is an exception for real estate professionals. These professionals are considered a trade or business and not passive. To realize this treatment, the taxpayer has to make an election with their tax return. The taxpayers made this election in the Franco case.
The benefit of the real estate professional election is that the taxpayers may be able to offset their ordinary income, such as the self-employment income in the Franco case, with their rental real estate losses.
Real Estate Professionals
Who exactly is a real estate professional? The Code uses the term “real property trade or business.” A “real property trade or business” includes:
any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
The real estate professional rules set out a two-part test that has to be met:
- more than one-half of 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 and
- the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
You can read more about these passive activity loss tests here.
If these tests are met and an election is made, the taxpayer can get the benefits of being a real estate professional.
In this case, the taxpayer-husband had two activities in 2013. He was a self-employed architect. He also managed the two rental properties.
According to the taxpayers, the husband spent 650 hours as an architect in 2013 and 1137 hours managing his rental properties.
Oddly, the taxpayers did not claim that the husband’s time as an architect counts toward the 750 hour requirement or factor into the 50% limitation. This is an open question that has not yet been resolved. It seems highly likely that this time does in fact count for the passive activity loss rules.
The taxpayers also did not take the position that the taxpayer-wife was the real estate professional.
The court only considered the 1137 hours the taxpayer-husband managing rental properties.
Substantiating Real Estate Professional Hours
The court described the activities the taxpayer-husband performed:
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.
The taxpayers presented testimony and records in support of their 1137 hours for these activities.
These records included a time log, receipts and invoices for repairs, and emails with tenants. These records were corroborated with the husband’s testimony about tenants moving out, tenants not taking out the trash, etc.
Importantly, the evidence did not include anything about the taxpayer having a property manager. The lack of a property manager tends to show that the taxpayer-husband did in fact manage the two rental properties.
The court concluded that this evidence was sufficient to establish that the taxpayer-husband was a real estate professional.
It should be noted that the court did not separate out the investor time, which the IRS often does on audit. Paying bills and keeping books and records for tax accounting purposes is almost always cited by IRS auditors as non-qualifying investor time.
This case shows how one might document their real estate professional hours. This is the outcome many would-be real estate professionals want. A close reading of this case is warranted for those who are considering how to document their hours.
It should also be noted that the taxpayers avoided a dispute involving the husband’s architect hours. It seems they could have prevailed by including those hours as well.
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