Election to be a Real Estate Professional

Taxpayer fails to qualify as a real estate professional under PAL rules

Kutney, TC Summary Opinion 2012-120. The Tax Court has concluded that a taxpayer, who also engaged in a consulting activity, wasn't a real estate professional for purposes of the passive activity loss (PAL) rules. He failed to show that more than half of the personal services that he performed during the year were performed in real property trades or businesses in which he materially participated.

RIA observation
This case illustrates how difficult it is for a taxpayer to qualify as a real estate professional for purposes of the PAL rules and the necessity of taking steps to document the extent of your required participation in that activity.

Background
Under Code Sec. 469(c)(1), the PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. In general, any rental activity is per se a passive activity regardless of the taxpayer's participation in the activity. (Code Sec. 469(c)(2)) However, there are an exceptions to the per se rule for: (a) real estate professionals; and (b) up to $25,000 of losses, subject to an adjusted gross income (AGI) phase out.

Under Code Sec. 469(c)(7), the per se rule for rental activities doesn't apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if:

1. More than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and
2. He performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates. For taxpayers filing a joint return, either spouse may separately satisfy the real estate professional requirements.

If a taxpayer is a qualifying real estate professional, the PAL rules generally are applied as if each interest of the taxpayer in real estate were a separate activity. But, under Code Sec. 469(c)(7), the taxpayer may elect to treat all his interests in rental real estate as one activity. (Reg. § 1.469-9(g)(1)) The election is made by filing a statement with the taxpayer's original income tax return for the tax year. This statement must contain a declaration that the taxpayer is a qualifying taxpayer for the tax year and is making the election under Code Sec. 469(c)(7)(A). (Reg. § 1.469-9(g)(3))

Facts. During the years at issue, John Kutney, an aeronautical engineer, engaged in independent engineering consulting work. He also owned several rental properties and rented out two of these properties. Kutney managed these two apartment complexes and contracted with Eduardo Langdon and others to do maintenance and repair work. Kutney paid for all materials and oversaw the work that Langdon and his crew performed.

Kutney kept no separate bank account for these rental activities and used his personal account to pay expenses. He kept no contemporaneous log or other documentation to record the number of hours he spent working on his rental properties.

On his returns, he claimed loss deductions from his rental real estate activities on his Schedules E totaling $29,950, $27,250, and $79,360 for 2005, 2006, and 2007, respectively. He made no election to treat all of his rental properties as a group. He also did not complete line 43 on any of his Schedules E to indicate that he considered himself to be a real estate professional. On audit of his return, along with other deductions, IRS challenged his real estate deductions, contending that they were subject to the PAL limitations.

Deductions denied. The Tax Court denied the deductions for the real estate losses sustained during the years at issue because they were passive activity losses. It found that Kutney failed to demonstrate that he satisfied the first part of the test in Code Sec. 469(c)(7) and so wasn't a real estate professional.

The Court wasn't convinced that Kutney performed more than one-half of his personal services in real property trades or businesses. He maintained no contemporaneous log of the time he spent working on these activities and provided no other documentation to establish the number of hours that he spent on these activities. His testimony regarding the time he spent on his consulting activities and his rental real estate activities was vague and indefinite. While he testified that he spent half his time on each, he also testified that he spent 153 hours during the year working on his consulting activities and between 1,619 and 2,912 hours working on his rental real estate activities. At different points, Kutney claimed to have spent 48 hours per week, 28 hours per week, and 14 hours per week working on his rental properties. Moreover, he also testified that Langdon performed most of the work on the rental properties during the years at issue.

The Court also rejected Kutney's contention that ownership and management of the rental properties was a full day activity that required him to be available all day every day and that these on-call hours should count towards the 750-hour requirement. The Court found that merely being on call to perform services wasn't sufficient.

While noting that Reg. § 1.469-5T(f)(4) allows an individual to show his participation in an activity by any reasonable means and that contemporaneous daily time reports, logs, or similar documents aren't required, the Tax Court concluded that the regulations weren't satisfied by a post-event “ballpark guesstimate.”