The ability to generate current year tax losses is a strong incentive for high-income taxpayers to own real estate.
Real estate often produces tax losses, but not economic losses.
This happens because the current operating expenses plus tax depreciation result in a current year loss. At the same time, the property likely increased in value during that year. So the real estate generates a current-year tax loss, while the value of the real estate property increases.
The IRS often challenges these tax benefits. The IRS has a number of rules that its disposal to do so. This includes the passive activity loss rules.
The passive activity loss rules were enacted in the late 80’s to limit the tax benefits associated with real estate. Nearly forty years later, the passive activity loss rules are still being challenged and, as a result, clarified by the courts.
The recent Eger v. United States, No.19-17022 (9th Cir. 2020), adds to this body of law. The case clarifies what counts as a “rental activity” for purposes of the passive activity loss rules.
Facts & Procedural History
The taxpayers in this case owned thirty three rental properties.
This court case involved three of the properties. The three properties are located in Mexico, Colorado, and Hawaii. The case refers to these three as “resort” properties.
The resort properties were subject to property management agreements. These agreements allowed third-party property managers to rent out the properties. They also restricted the taxpayers’ ability to use the properties personally.
On their tax return, they asserted that they were real estate professionals. They also elected to group all 33 of their properties as one rental activity.
On review by the IRS, the IRS agreed that the taxpayers were real estate professionals. However, the IRS concluded that the resort properties could not be grouped with the 30 other properties.
Tax litigation ensued. The district court found for the IRS and the taxpayers appealed the decision.
The Real Estate Professional Rules
While not in issue in this case, it is helpful to pause to consider the real estate professional rules.
The real estate professional rules are an exception to the passive activity loss rules. The passive activity loss rules limit the ability to deduct losses from rental properties.
As an exception to the general rule that “rental losses are passive,” the real estate professional rules allow taxpayers to deduct rental losses against non-passive income.
A common example is a taxpayer-spouse who earns ordinary wages from a job. Wages are ordinary income and very few deductions are allowed to offset wage income (this is particularly true since the enactment of the Tax Cuts & Jobs Act, which took away the ability to deduct unreimbursed employee expenses). If the real estate professional exception applies, the wage earner can effectively reduce his income tax liability by offsetting the income with rental losses.
These can be difficult concepts to explain to IRS employees, as IRS employees often do not understand the concept of why someone would work more than 40 hours a week or have a second job.
The Grouping Rules
Now we can consider the grouping rules. The grouping rules are important as they make it possible for taxpayers to qualify as real estate professionals.
When viewing the taxpayer’s activities, he has to count the amount of time he spent on real estate activities each year. This real estate time is compared to non-real estate time. The rules are nuanced, but generally, the taxpayer has to work 750 or more hours in real estate activities and no more than 50% of his time can be for non-real estate activities.
Absent an election to group properties as one activity, this 750-hour test is applied on a property by property basis. There are rules for which properties can be grouped. Generally, the grouping is up to the taxpayer. The taxpayer just has to have some logical explanation for the grouping. This may be the geographic locations of the properties, types of property, etc. This grouping election is made by including a statement with the tax return.
What Counts as a Rental Activity?
This brings us to the issue in this case, namely, what counts as a rental activity.
The regulations generally define the term “rental activity” as an activity involving holding of tangible property for the use of customers:
an activity is a rental activity for a taxable year if –
(A) During such taxable year, tangible property held in connection with the activity is used by customers or held for use by customers; and
(B) The gross income attributable to the conduct of the activity during such taxable year represents (or, in the case of an activity in which property is held for use by customers, the expected gross income from the conduct of the activity will represent) amounts paid or to be paid principally for the use of such tangible property (without regard to whether the use of the property by customers is pursuant to a lease or pursuant to a service contract or other arrangement that is not denominated a lease).
The regulations go on to provide several exceptions. One of the exceptions says that an activity involving the use of tangible property is not a rental activity if “[t]he average period of customer use for such property is seven days or less.”
This rule was the subject of the dispute in this case. According to the IRS, the properties were not rentals as the average period of customer use of the end-user guests was less than seven days.
The taxpayers apparently agreed that the units were actually rented to those who would stay in the properties less than seven days. They disputed that the end-user is the “customer,” however. They argued that the customer was the property manager. The argument is that the property managers rented the properties from the taxpayers pursuant to their property management agreements. Since these property manager agreements were for more than seven days, the activities qualified as rental activities.
The district court, and now on appeal, the appeals court, agreed with the IRS. They both concluded that the end-user of the real estate is to be considered. Since the end-users apparently used the property less than seven days (as the taxpayers did not argue otherwise), the resort properties were not rental activities.
The net result is that that losses from the resort properties were not rental losses. This means that the expenses for the properties were likely not deductible at all (the taxpayers may still be able to deduct the real estate taxes and/or interest for one or two of the properties as their primary and/or vacation properties).
Those who have short term rental properties should take note of this case. The property management agreements, in this case, are somewhat standard. Taxpayers who have similar arrangements should revisit whether they are deducting real estate losses for these properties.
Taxpayers may want to consider making changes to their property management agreements. A little real estate tax planning may allow taxpayers to avoid the issue in this case. Taxpayers are free to arrange their affairs as they see fit. The property management agreements, in this case, could have been written differently.
For example, they could have specifically said the property manager is the tenant, that the properties are rented for the full year, and that the end-user (property manager) has the right to sublet the properties. This type of arrangement is common in the corporate housing leasing space. The result in this case may have been different had the property management agreement been structured in this manner.