Like a great teacher, Judge Kerrigan has used two different cases in the Tax Court to illustrate how a taxpayer can substantiate his activities to qualify as a real estate professional under § 469(c)(7). One case is Lewis v. Comm’r, T.C. Summ. Op. 2014-112 and the other is Flores v. Comm’r, T.C. Memo 2015-9. Lewis shows how to substantiate a taxpayer’s activities even without creating a log and Flores shows how NOT to substantiate the taxpayer’s activities.
To give these cases some context, § 469 limits losses associated with a passive activity by allowing 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. Both of these cases illustrate the application of the spousal attribution rule in a passive activity loss context.
In Lewis, the IRS challenged the taxpayers’ deductions from 2010 and 2011 associated with the rental of an apartment triplex. The taxpayers owned a triplex and rented out the units, with the taxpayer-husband, a Vietnam veteran who is 60% disabled due to his service in the Marine Corps, managing the rental property. Mr. Lewis devoted all of his time to activities related to the rental business and did not employ others to assist him with the rental business. The activities he performed every week included administrative tasks such as collecting and depositing rent and maintaining records of rental payments. He also performed routine maintenance at the rental property for several hours three different days a week.
The specific issue before the Tax Court in Lewis was whether the taxpayers qualified for the “real estate professional” exception under § 469(c)(7). In Lewis, the first prong of the real estate professional exception was not in issue because Mr. Lewis’ activity with respect to the triplex was his sole activity. Accordingly, the only issue to examine was whether Mr. Lewis satisfied the 750 hour test.
The court first noted that contemporaneous daily logs are not necessary to prove the hours of participation, but ballpark guesstimates are not acceptable. Narrative summaries given through credible testimony are a reasonable means to establish the hours of participation in a given activity. Based on the testimony of the taxpayers, the Tax Court determined that Mr. Lewis spent 650 hours a year on just the routine maintenance at the rental property. Thus, the court concluded that when you add in his non-routine activities, Mr. Lewis’ total hours of participation in the rental business easily eclipsed the 750 hour threshold. The IRS argued that the taxpayers inflated the amount of time Mr. Lewis spent performing given tasks. The IRS forgot that it is usually not smart to attack a disabled vet; in Lewis the Tax Court noted that Mr. Lewis was 63-64 years old and was a disabled veteran so it was quite credible that he spent the amount of time he claimed performing his various tasks with the rental property.
In Flores, the Tax Court again examined whether (a less believable) taxpayer qualified as a real estate professional. Similar to Lewis, the taxpayers owned one rental property—a condo—in which Mr. Flores managed the rental property. However, unlike Lewis, the taxpayer-husband in Flores maintained a separate full-time job (that did not qualify as a real estate trade or business). The taxpayers reported $15,648 dollars of income and $26,138 of expenses from the rental activity.
After first determining that the condo rental activity constituted a real property trade or business in which Mr. Flores materially participated, the court then examined whether Mr. Flores met the requirements of a real estate professional. In discussing the first prong, the court noted that Mr. Flores spent approximately 1,294 hours working as an employee in a non-real property trade or business. Thus, the court stated that Mr. Flores would need to spend more than 1,294 hours in a real property trade or business in which he materially participated to satisfy the first prong of the real estate professional exception.
The court next discussed the second prong of the real estate professional test and took exception with the taxpayers’ evidence (in the form of logs and calendars) demonstrating more than 750 hours of participation in the rental activity. The court just did not buy his story even though the calendars and logs presented to IRS indicated Mr. Flores spent 799 hours in the rental activity. It is noteworthy that Mr. Flores testified that some of the entries were inaccurate and gave inconsistent testimony regarding a second calendar that was not admitted into evidence. Ultimately, the court concluded that neither Mr. Flores nor Mrs. Flores satisfied either prong of the real estate professional exception.
Time and again the Tax Court has reiterated that contemporaneous daily logs are not required to substantiate hours of participation in a particular activity. In Lewis, the taxpayers testified credibly to the amount of time spent in the real property activity, and the Tax Court provided a de facto log to conclude that Mr. Lewis satisfied the real estate professional exception. In contrast, in Flores, the taxpayers did provide logs and calendars, but due in part to inaccurate entries and inconsistent testimony, the court found that Mr. Flores did not qualify as a real estate professional.
The lesson should be clear—credible evidence, whether logs, calendars, or narrative summaries, is required to establish the participation in a given activity. These cases clearly illustrate the importance of credibility on how a story will be received by the Tax Court and are instructive on how future cases involving the existence of a real estate profession should be presented.