In the complex realm of the legal system, judges hold the vital responsibility of making impartial decisions, drawing from their wealth of life experiences. These experiences, in turn, have a profound influence on the judgments they render.
This principle extends to other government officials as well, such as IRS agents, auditors, and attorneys, who are entrusted with decision-making on behalf of the government.
A significant challenge arises when addressing certain cases that require conveying complex concepts to government employees whose daily experiences do not encompass the same economic systems as businesses and non-government individuals. Consequently, these employees may not really understand the practices and motivations that drive the private sector.
What may be readily accepted as fact by those outside of government service can be met with skepticism and unfamiliarity by government employees. For instance, the challenge of establishing that one works more than 80 hours a week at two different jobs is not easy as government employees typically do not work more than 80 hours a week–and do not have two jobs.
This is exactly what taxpayers have to prove to the government to qualify for “real estate professional” status to take losses from rental real estate. This is a very difficult task. The recent court case, Drocella v. Commissioner, T.C. Summ. Op. 2023-12, serves as a prime example of this.
Facts & Procedural History
The taxpayers were husband and wife. They both had full-time jobs in 2018.
They also owned and managed six rental real estate properties, and worked on renting and renovating them.
The parties provided handwritten logs containing dates, times, and notations of work performed on the properties, which totaled 1,501.27 hours. The hours listed on the logs for the husband exceed 750, but the total hours listed on the logs for the wife do not equal or exceed 750.
The taxpayers reported $160,000 in wages and a $62,000 loss from the rental properties on their 2018 tax return. The IRS audited the tax return and disallowed the loss. The taxpayers filed a petition with the U.S. Tax Court to challenge this decision.
About the Passive Activity Loss Rules
Sections 162 and 212 allow taxpayers to deduct ordinary and necessary expenses for carrying on a trade or business or producing income.
The passive activity loss rules were enacted in the late 1980s to prevent taxpayers from using real estate as a tax shelter. Real estate is capital-intensive and, often, debt-financed. This can result in real estate holdings that produce losses due to purchase prices and financing costs, which, viewed long term, can make economic sense for investors. As long as the appreciation outpaces the costs, it is a timing issue. The increase in value is worth more than the current year’s out-of-pocket losses.
Our income tax system does not account for this long-term view. The system measures income and loss for income tax purposes on an arbitrary one-year period. Each period stands on its own. Long-term investors have losses each year, which can reduce their income taxes each year, but the investor ends up winning long-term.
The passive activity loss rules are Congress’ attempt to limit losses for certain real estate investors. The passive activity loss rules generally say that a taxpayer’s rental activity is generally considered passive, and any losses from that activity can only be used to offset passive income. There are grouping rules that can help by allowing taxpayers to combine activities.
Congress provided some clear paths in the rules that draw distinctions for those who can and should get to deduct their real estate losses. The real estate professional rules provide an example.
Real Estate Professional Rules
To qualify as a real estate professional under the passive activity loss rules, a taxpayer must meet two criteria.
First, more than half of the personal services performed in all trades or businesses during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
There are several ways the material participation rules can be met. The catch-all rule for material participation looks to whether the taxpayer is involved in the operation or management of the rental property on a regular, continuous, and substantial basis. This can include activities such as advertising for tenants, screening tenants, collecting rent, and maintaining the property.
DID YOU KNOW?
Many taxpayers may be surprised to learn that, despite being classified as a real estate professional, they still need to satisfy the material participation requirements for real estate activities.
This can be confusing since meeting the requirements to be considered a real estate professional often satisfies the material participation tests.
Not Real Estate Professionals
That brings us to the court’s holding in this case. The court held that the taxpayers were not real estate professionals as they could not show that more than half of the personal services were performed in real property trades or businesses.
The court reached this conclusion as the taxpayer’s employment counts in the denominator. The numerator just includes the real estate activity time. The denominator includes real estate activity time and employment time. Thus, since both taxpayers were employed full-time, they would have to provide the number of hours they each worked for their employers.
The taxpayers did not do that in this case. They stipulated to the fact that they worked full-time. They did not stipulate to a specific number of hours. This led the court to conclude that it could not compute the ratio described above. This is no different than the outcome in other similar tax court cases.
Had the taxpayers simply provided their paystubs or other evidence of hours worked for their employers, they might have prevented the court from reaching this conclusion. But reading the opinion, it seems like the court would have reached the same conclusion but it would have instead said that it did not find the taxpayer’s testimony credible. The U.S. Tax Court often does this.
The Real Estate Problem
This is a case where the taxpayers were probably real estate investors. It is likely that they did actually qualify under the rules. Real estate is time-intensive. Those who own and manage real estate know that six rental properties that are self-managed are more than a full-time job.
This case highlights the problem with the real estate rules. It shows the challenge real estate investors have in persuading government employees that someone would work more than 40 hours a week and take risks that result in losses each year. These are often foreign concepts to government employees.
Government employees–such as IRS auditors, IRS attorneys, and tax court judges–have no need to work more than 40 hours a week. They mostly live and experience an eight-hour workday with so many days off each year–well beyond what the private sector gets. They operate in a system that prevents their employer from asking for more than this. To have to work on what the private sector doesn’t even count as a holiday is unheard of. And they also do not need to worry about building wealth as they will not outlive their earnings. They get a retirement payout guaranteed by the government.
From this privileged vantage point, one can see why government employees would not believe that someone would actually work hard outside of their job as an employee, sometimes having more than one job, and doing so out of fear of running out of money for retirement. These foreign concepts are the very reasons why folks invest in real estate and work so hard and put so much time into real estate to make real estate work.
It is very difficult to convince government employees that anyone qualifies as a real estate professional if they have a full-time job. This is a foreign concept to government employees. As this case shows, taxpayers who litigate real estate professional status need to ensure that they get the total hours employed by their employer in the record. This may include timesheets from their employers, an affidavit from their employer, or even evidence of their hourly rate (if they are not salaried). And preferably, the number of hours worked as both employees and in real estate should be stipulated to with the IRS in advance.
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