Determining Who Is a Real Estate Professional Under the
Several tests are involved requiring various hour counts and elections.
March 21, 2011
In a report released March 9, 2011, the Treasury Inspector General for Tax Administration advised the Internal Revenue Service (IRS) to increase its examination of individual tax returns reporting losses from rental real estate. Because of the potential increased focus on the audit of returns showing rental real estate losses, it is important to understand which taxpayers are entitled to deduct losses from rental real estate as ordinary losses rather than having to treat such losses as passive under Code Section 469(c)(2).
To escape passive-loss classification, the taxpayer must qualify as a “real estate professional” and must materially participate in the rental activity. I.R.C. § 469(c)(7). (Reader Note: This is not the only way to avoid passive loss. There is also the exception for up to $25,000 of losses of an active participant in a rental real estate activity under 469(i).) Section 469(c)(7)(B) requires that a taxpayer meet two tests in order to be considered a real-estate professional for a taxable year. Those tests are:
The first test — set forth in Section 469(c)(7)(B)(i) — becomes an issue only if the taxpayer is involved in an occupation in addition to real estate. In contrast to the 750 hour test set forth in Code Section 469(c)(7)(B)(ii), neither Code Section 469(c)(7)(B)(i) nor Treasury Regulation § 1.469-9 requires the taxpayer to count hours to prove that the 50-percent test has been satisfied. How to meet this test, other than by counting hours, is a difficult question. The IRS certainly counts hours in determining whether a taxpayer meets this test. The courts in deciding the issue of “real estate professional” have not expressly dealt with this test; rather, they use the fact that the taxpayer spent time in an occupation outside of real estate to buttress their conclusions that taxpayers have not met the 750-hour test.
Usually taxpayers do not keep a diary of their activities. Thus, many real estate people lose rental loss cases because they cannot substantiate that they worked more than 750 hours in those real property trades or businesses listed in Code Section 469(c)(7) or that they met the materially participated in those trades or businesses. Even though Treasury Regulation § 1.469-5T(f)(4) provides that a taxpayer can use “any reasonable means to prove participation in an activity” and that “contemporaneous daily time reports, logs or similar documents are not required if the extent of such participation may be established by other reasonable means,” numerous court cases show that the courts have hesitated to accept a taxpayer’s post-event narrative of participation when deciding whether the taxpayer qualifies as a “real estate professional” or has “materially participated” in an activity. Courts often hold that testimony based on receipts, photographs and letters constitute post-event “ball-park guesstimates” that are insufficient to prove that the hours claimed were actually hours worked by the taxpayer.
From all of the court cases using the phrase “ball park guesstimates,” it can be concluded that “contemporaneous time logs” are, in fact, required to show hours worked even though Treasury Regulation § 1.469-5T(f)(4) expressly states that contemporaneous daily time logs are not required if the extent of such participation may be established by other reasonable means. In accordance with this Regulation, there are cases in which the taxpayer did not keep contemporaneous time logs, but the taxpayer did establish hours spent in an activity “by other reasonable means.” Trask v. Commissioner, T.C. Memo. 2010-78; Harrison v. Commissioner, T.C. Memo. 1996-509. In both cases, the taxpayer could point to specific activities, which supported his claim of hours spent. For example, in the Trask case, the Tax Court concluded the taxpayer met the 750 hour test based upon his evidence that he handled over 80 issues for 11 pieces of property. If your client has not kept a diary, rather than creating vague lists of activities purportedly performed on ordinary rental properties, look to see if you can substantiate the hours claimed by pointing to specific activities requiring significant blocks of time.
To meet the 750-hour test, the taxpayer can only count those hours spent in those real-property trades or businesses listed in Code Section 469(c)(7)(C) in which there was material participation in the real property trades or businesses. The real-property trades or businesses that qualify are: development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. In the case of Agarwal v. Commissioner, T.C. Summ. Op. 2009 – 29, the taxpayer spent more than 750 hours working as a licensed real-estate agent. Because “licensed real-estate agent” is not listed in Section 469(c)(7)(C), the question was whether those hours counted under Code Section 469(c)(7)(C) as “broker” hours. Because the Tax Court answered the question in the favor of the taxpayer, their losses from the two rental properties for which they showed material participation were ordinary.
Material participation is determined under the seven tests set forth in Treasury Regulation § 1.469-5T. To prove “material participation,” Treasury Regulation § 1.469-9(d)(1) allows grouping real-property trades or businesses based upon facts and circumstances. However, rental activities cannot be grouped with other real-property trades or businesses. Treasury Regulation § 1.469-9(e)(3)(i).
Example: Assume a taxpayer spent 450 hours reconstructing and redeveloping the basement of a rental building and 310 hours on building rental. (Note that reconstructing and redeveloping activities may be grouped together.) The taxpayer wants to show material participation in the reconstruction and redevelopment activity under the 500 hour test set forth in Treasury Regulation § 1.469-5T(a)(1)(4) and material participation in the rental activity under the 100 hour test set forth in Treasury Regulation § 1.469 – 5T(a)(3). The taxpayer has met the material-participation test for rental. The taxpayer, however, has not met the material participation test for reconstruction and redevelopment activity because he did not spend more than 500 hours doing that type of work. Therefore, the taxpayer has not met the 750-hour test — he cannot combine the 450 hours spent on reconstruction and redevelopment with the 310 hours spent on rental because he did not show materially participation in reconstruction and redevelopment. To combine the hours to reach 750, he must have material participation in redevelopment and reconstruction and he must have material participation in rental.
Grouping Rental Properties
Grouping rental properties has its own special rule. A real-estate professional cannot group rental properties together to determine “material participation” in rental for a taxable year unless he elects to treat all rental properties as a single rental activity by filing a statement with his original income tax return for the taxable year. I.R.C. § 469(c)(7)(A) & Treas. Reg. § 1.469-9(g)(3). Merely aggregating rental income and expenses on Schedule E does not suffice. The Tax Court in Trask, supra held that the taxpayer was a real-estate professional, but his failure to file an election caused him to fail the material participation test for rental. Without an election, the taxpayer must examine each rental property to determine whether he materially participated in the rental of that property.
This article only provides an outline on determining whether a taxpayer is a real-estate professional. However, hopefully it shows how difficult such a determination can be.
Janice Eiseman, JD, LLM, is a principal at Cummings & Lockwood in Stamford, Conn. office where she focuses on the taxation of closely held businesses and tax planning for owners and investors. Eiseman has broad-based experience counseling clients on the formation, ownership and structuring of various business entities, as well as drafting and negotiating tax-based and transactional documentation for both individual and business clients. She has also done controversy work before the Internal Revenue Service and the New York State Department of Taxation and Finance. Prior to joining Cummings & Lockwood, she served as senior tax and benefits counsel at the New York City-based law firm Morrison & Cohen LLP.