If an individual owns an interest in a business in which he does not materially participate, he is subject to the Code’s passive activity loss limitations. In general, tax losses from a passive activity can only be deducted against income from a passive activity until the year in which the entire interest in the passive activity is sold. There are a number of ways in which an individual can materially participate in a business, the principal one of which is working in connection with the business for at least 500 hours during the tax year.
The ownership of income-producing real property is always a passive activity for an individual unless he is actively engaged in a real property trade or business as provided under Section 469(c)(7)(B) of the Code (such a person is often referred to as “real estate professional”). One of the requirements to qualify as a real estate professional is that the individual must spend at least 750 hours working in his real property businesses.
Clients often ask us what they must do to prove that they worked either the 500 or 750 required hours for purposes of the passive activity loss rules. The Tax Court shed some light on these requirements in the recently decided case of Daco v. Commissioner (September 9, 2013). The taxpayer claimed to be a real estate professional and, as a result, the losses produced by his rental properties were not subject to the passive activity loss rules. In order to prove his 750 hours of participation, he prepared written summaries of his time and activities and also testified about his time and activities at the trial. In rejecting his claims, the court found the written summaries untrustworthy because they were created in preparation for the trial, rather than kept contemporaneously by the taxpayer. The court also found his testimony at the trial to be uncorroborated and self-serving.
The regulations provide some leeway to taxpayers as to how they keep track of their time, but it seems clear that in most cases a taxpayer is going to need some kind of contemporaneous written records. We believe that keeping either daily time sheets or making daily calendar time entries and notations are the best means of creating a record that can be used later to prove your level of participation.