The Tax Court recently entered two decisions concerning material participation by taxpayers claiming real estate professional status that reached opposite conclusions. This is a hot area for IRS audit activity and shows the importance of maintaining accurate records of how much time a taxpayer may spend in his or her real estate and non-real estate activities.
In Penley v. Commissioner, T.C. Memo. 2017-65, the taxpayer failed to demonstrate to the Tax Court that he was a real estate professional under the regulations due to poor substantiation and unreasonable estimates of the time spent in his real estate activities and his non-real estate job. By contrast, in Windham v. Commissioner, T.C. Memo 2017-68, the Tax Court found that the taxpayer did substantiate the time she spent working on her rental properties, as well as the time she spent at her full-time, non-real estate job, and that therefore, she satisfied the test for being a real estate professional.
The major difference between these two cases was the reasonableness of the time the taxpayers claimed to spend at their full-time jobs and in connection with their rental real estate activities. The law provides that a qualified real estate professional may treat losses in connection with rental real estate activities as non-passive losses, which means they are not subject to the passive loss limitation rules under Internal Revenue Code section 469. Otherwise, rental real estate activity losses are normally considered “passive” and can only be used to offset passive income under section 469.
A taxpayer qualifies as a real estate professional if (1) more than half of the taxpayer's hours spent working in a trade or business are performed in connection with his real estate business, and (2) the taxpayer spends more than 750 hours in the year working on his real estate business.
Taxpayers who want to qualify as real estate professionals must track their time performing services in the real estate business to meet the 750-hour threshold. In addition, taxpayers should also document the time spent in their “full-time” (non-real estate) job, to show that more than half of their working hours are dedicated to their real estate business.
The taxpayer in Windham is a long-standing (30-plus years) financial advisor/stock broker for a national brokerage firm. Additionally, she owned eleven rental properties that she managed and operated. To convince the Court that she was a real estate professional, she provided compelling testimony, as well as a calendar and other corroborating evidence, to convince the Court that she worked as a financial advisor from 12:30pm until the markets closed on days when the financial markets were open, and that she worked in her real estate activities during mornings and on the days the markets were closed (weekends and holidays). Based on the testimony and the corroborating evidence provided, the Court concluded that the taxpayer only spent 577.5 hours working at her “full time” job as a financial advisor/stock broker. By contrast, the Court found that the taxpayer demonstrated that she spent a total of 889.25 hours working on her 11 rental real estate properties. Therefore, she met both elements of the real estate professional test.
The evidence in Penley, however, showed that the taxpayer worked over 2,000 hours at his “full-time” job as a sterilization technician and sales account representative. In addition, the taxpayer provided testimony and evidence that he spent 2,520 hours working on his rental real estate activities, which meant he was working 10-14 hours each Saturday and Sunday and 4-6 hours most weekdays. The Court did not find this testimony credible and found that the overall hours claimed by the taxpayer would not have left him with any time for meals, family, or any other breaks. The Court concluded that the taxpayer's substantiation was insufficient and not credible and that he did not qualify as a real estate professional.
These two cases demonstrate the importance of documenting not only the hours in one's rental real estate activities (to meet the 750 hour test), but also the importance of documenting the hours in one's full-time job (to meet the more than half test). It also shows the importance of believable testimony and corroborating evidence in cases involving real estate professional status.
This is a very active area for the IRS, which is challenging real estate professional status regularly. These and other cases (that we have described in former blogs) should give taxpayers claiming real estate professional status an incentive to keep accurate time records and corroborating testimony that will be useful to defend an audit in this area. (Click here and here to link to our prior articles on this issue)