The Tax Court recently determined in Lopez v. Comm’r, T.C. Summ. Op. 2015-22 that the taxpayers, a married couple, failed to produce credible evidence to substantiate their deductions as real estate professionals under § 469(c)(7). We previously discussed the importance of detailed and credible record keeping for purposes of the passive activity loss rules. Lopez illustrates this point and highlights the importance of the credible in credible evidence.
In Lopez, the taxpayers owned four rental properties in California and one property in South Carolina, which was occupied by Mrs. Lopez’s mother. Section 469 prohibits losses associated with a passive activity and allows passive deductions only to the extent of passive income. Rental activities are considered per se passive, and thus losses from rental activities are generally only deductible to the extent of passive income. However, taxpayers may rebut this presumption by establishing that they meet the requirements of a real estate professional and that they materially participated in the rental activity.
There are two prongs to the real estate professional exception. First, more than one-half of the personal services performed in a trade or business during the year by the taxpayer must be performed in a real property trade or business in which the taxpayer materially participates. Second, the taxpayer must spend more than 750 hours in a real property trade or business in which the taxpayer materially participates. In the case of joint returns filed by spouses, if either spouse qualifies as a real estate professional, then the per se presumption of the rental activity being passive is rebutted. A spouse’s real estate professional status is determined only with respect to the spouse’s activities; and does not include the activities of the other spouse. This contrasts with the material participation rule that allows spouses to “pool” their collective activities to prove material participation.
In Lopez, the court only analyzed the 750 hour requirement and found that both Mr. and Mrs. Lopez fell well short of satisfying the minimum hours required under § 469(c)(7). The taxpayers claimed that Mr. Lopez spent over 900 hours on rental activities in 2009. The Tax Court has previously stated that taxpayers may prove their hours of participation in a variety of ways, including logs, calendars, or narrative summaries detailing the hours spent on a particular activity.
While, the taxpayers produced receipts, documents, a log, as well as testimony to attempt to substantiate the hours spent on the rental activity, the Tax Court found all of this evidence to be flawed. For example, the taxpayers produced several different variations of logs that all contained discrepancies and inaccuracies. Moreover, a receipt was produced to substantiate hours spent painting one of the properties, but the address was intentionally covered to hide that the taxpayers’ son lived at the property. The taxpayers provided another receipt to substantiate hours spent working on a rental property, but in fact the receipt was for work performed on the taxpayers’ personal residence.
Although the form of evidence may vary to substantiate hours spent on a given activity, one constant remains—the evidence must be credible. In upholding accuracy related penalties in Lopez, the court stated “that petitioners’ exaggerated logs and testimony negate their good faith in claiming rental losses against their earned income.” The lesson on this point is clear. Presenting credible, consistent, and truthful facts is important. Thus, honestly presenting evidence—whether for the IRS or for the taxpayer—is vital to success.