Tax cases are interesting in that they apply a fairly well-developed set of rules to varying fact patterns. These varying fact patterns can result in surprising, and often unintended, consequences.
The more complex the tax law in question, the more likely it is that the outcome will be something other than what Congress may have intended in enacting the law.
The passive activity loss rules provide a prime example. They are highly nuanced rules that disallow some tax losses and allow other tax losses.
As explained below, for those with rental real estate losses, these rules can require a taxpayer to spend more than 50 percent of their time on real estate. This test can be difficult to meet for someone who has a full-time job, as a job with a typical Monday through Friday work schedule breaks up the employee’s free time into small daily allotments. This leaves little free time during normal business hours. But what if that full-time job affords a lot of time off?
In the Whoriskey v. Commissioner, T.C. Summ. Op. 2021-30, case the court applied these rules to a taxpayer who worked a “24 on, 24 off” job. So he had large blocks of time off of his day job, which would seem to suggest that he could have focused this free time on rental real estate activities. The case is instructive for those who have rental losses and who work irregular hours in their day jobs.
Facts & Procedural History
The taxpayer was employed full-time as a firefighter. The court noted that he worked:
two 24-hour shifts per week throughout the years in issue. On an eight-day cycle he worked 24 hours on, 24 hours off, 24 hours on, five days off.
This work schedule allowed him to have significant blocks of time off of his job.
During this time, he apparently worked on the rental real estate he owned. This included five properties, one of which was a three-unit multifamily property.
He was a licensed realtor and managed and maintained the properties.
On his tax return, the taxpayer reported a loss from the rental activities.
On audit, the IRS auditor proposed to disallow his rental loss. Tax litigation ensued. One of the questions for the tax court was whether the taxpayer was entitled to take the rental loss reported on his tax return.
The Passive Activity Loss Rules
The passive activity loss rules were intended to limit tax shelters. They do this by limiting the ability to offset nonpassive income with passive losses.
For most taxpayers, nonpassive income usually means wages or earnings. Passive income often means rents.
The rules are nuanced, but generally, rental income is deemed to be passive.
Rental properties often require large capital investments. This comes in the form of down payments and then repairs and maintenance and then major capital investments to better or improve the property. These events can trigger tax losses in some years.
This is where the passive activity loss rules often come into play. High-income earners may not be able to offset their wages with their rental losses.
The Real Estate Professional Rules
The real estate professional rules are an exception. If the taxpayer qualifies, they can allow the taxpayer to treat losses as nonpassive.
There are several rules that have to be met to qualify as a real estate professional. These rules generally require the taxpayer (or their spouse, if a joint return) to perform 750 hours or more of work for their real estate. Absent a property manager, many hands-on owners satisfy this test. This is a mechanical test that just requires timekeeping records.
The rules for this exception also require the taxpayer to spend more than 50 percent of their working time on their real estate. It’s this second requirement that is often an outright bar. If the taxpayer has another full-time job, they may find it difficult to show that they spent 50 percent of their working time on real estate.
There are nuances to both of these rules.
In addition to these rules, the taxpayer also has to “materially participate” in the property. There is a list of how one can qualify as materially participating. The most onerous is that the taxpayer spends 500 hours a year on real estate. This test is met by default if the real estate professional rules are met, given that the 500 hours is less than the 750 hours for real estate professional status.
There are grouping rules that also apply here. Very generally, those rules say that taxpayers can group their passive activities for purposes of applying these rules. These grouping elections are made by including a statement with the taxpayer’s returns. This can help meet the 750 and 500-hour tests, for example.
Evidence to Establish Real Estate Professional Status
The court had little difficulty in deciding that the taxpayer was not able to deduct his rental losses. It noted that the evidence only included the taxpayer’s testimony and his work records.
The testimony included an estimate that he worked 500 hours on the real estate. This is less than the 750 hours that are required.
The work records showed that he worked full-time.
Given the facts, it is possible that the taxpayer could have qualified as a real estate professional had he put in more effort gathering and presenting evidence. This case provides an opportunity to consider what evidence might have been presented.
The 50 Percent Test
For the requirement that he spend more than 50 percent of his time on his real estate, the evidence could have included testimony from his co-workers as to how the work shift groups large blocks of time off, that this allows them to pursue outside activities, and their knowledge that the taxpayer spent his time on real estate.
The evidence could have included testimony from others that know of the taxpayer’s activities. This could include just about anyone that has knowledge of the taxpayer’s real estate activities. It could have even included testimony from the tenants.
This argument would seem to fit given the irregular hours the taxpayer worked. The irregular hours group his free time so that he had more time in bulk to work on his rental properties. This irregular work schedule could have given the taxpayer a head start on proving up his case.
Testimony alone would not be enough, however. Going beyond this, the evidence could have included receipts, invoices, bank records, calendars, time logs, mileage logs, emails, correspondence, etc.
This same evidence could have been used to establish that the 750-hour test was met.
You can read another court case where the taxpayer met this evidentiary burden here. In that case, the taxpayer only worked part-time. Thus, the 50 hour test was easier for him to meet (realtors also have a leg up for this test). The taxpayer in this other case provided a time log, receipts and invoices for repairs, and emails with tenants. These records were corroborated with his testimony about tenants moving out, tenants not taking out the trash, etc. and how he did not have a property manager for the property.
This is the type of evidence that was missing in this case. Evidence of irregular hours coupled with actual records might have carreid the day in this case.
Many real estate owners focus only on documenting the amount of their real estate losses. They neglect to document their activities. Those who have real estate losses need to take extra time to document the amount of the losses and their efforts for the rental properties. This should be part of their real estate tax planning. This is particularly true if the taxpayer wants to qualify as a real estate professional. The court cases show that those who take the time to document their activities are able to take these tax losses. Those with irregular work hours have a leg up in proving their case, but they still have to provide some records.