A New York State Administrative Law Judge has found that a New York resident met the criteria for a “real estate professional” and therefore could offset passive rental real estate losses against nonpassive income. Matter of Claudel Chery, DTA No. 825699 (N.Y.S. Div. of Tax App., Dec. 3, 2015).

Facts. Mr. Chery, the petitioner, claimed total rental losses of over $87,000, arising from two properties located in Brooklyn and Middletown. On the Brooklyn property, he reported rents of $64,650 and expenses of over $107,000; on the Middletown property, rents in the amount of $18,000 and expenses of approximately $63,000. During 2008, Mr. Chery resided in a condominium in the Bronx that he was also actively trying to rent out in order to move in with his wife, whom he married in 2008. Mr. Chery worked full time as a postal inspector and worked on his rental properties when not at his regular job, including performing repairs and maintenance and handling all management functions. Although he had been involved in real estate ownership and rental since 2003, in 2008 Mr. Chery first classified himself as a real estate professional and treated all his interests in rental real estate business activities as a single activity, including the required statements with his 2008 personal income tax return.

On audit, the Department of Taxation and Finance requested records regarding the properties, as well as detailed records of services performed and hours attributable to those services. Mr. Chery provided all the records, including a contemporaneously prepared vehicle log with 559 entries for 2008.  Although the vehicle log had been created with the intention of tracking mileage associated with business use of the vehicle, it also included explanations of the purposes of all the rental-related tasks listed, travel locations, miles traveled, hours spent, and other information. Based on the vehicle log, Mr. Chery calculated that he spent 1,872 hours on rental-related activities in 2008. He also provided a contemporaneously prepared electronic calendar and appointment book, with entries on 286 days, that largely correlated to the vehicle log entries, but also recorded additional time for tasks that had not involved travel, ranging from 10 to 20 hours a month.

Mr. Chery also spent time consulting on real estate projects, conducting business under the name CLC Property Management (“CLC”), for which he maintained separate books and records, including a business bank and credit card account, a separate vehicle, tools, a website, and space used exclusively for storage of supplies for the CLC business. He used as his principal site for his rental businesses a home office at his Bronx address, keeping records of trips between that office and his Brooklyn or Middletown properties.

After review of the records, the Department stated that Mr. Chery identified 2,047 hours spent as a U.S. postal inspector, and only 1,872 hours spent on rental properties, and that some of those 1,872 hours did not count, claiming that, for example, some of the work was done before Mr. Chery actually owned the properties, was spent on work not customarily done by an owner, or was for a property that was not leased at the time. Mr. Chery responded with a detailed written response, providing specific responses to the Department’s challenges, including details on his experiences repairing properties since his childhood.  The Department nonetheless issued a Notice of Deficiency in April 2012. Mr. Chery continued to submit additional supporting information, and in response, for the first time, after the Notice had already been issued, the auditor characterized additional hours identified by Mr. Chery to be hours spent on a “hobby.”

The Dispute. New York follows federal law on passive rental losses.  Section 469(a) of the Internal Revenue Code generally disallows passive activity losses, which  are defined as the excess of the aggregate losses from all passive activities over aggregate income from all passive activities. A passive activity is any trade or business in which the taxpayer does not materially participate, under IRC § 469(c)(1), and a rental activity is generally treated as a per se passive activity whether or not the taxpayer materially participates. IRC § 469(c)(2), (4). However, there is an exception for rental activities of “real estate professionals,” which are treated as a trade or business, subject to the “material participation” requirements of § 469(c)(1) and Treas. Reg. § 1.469-5T(e)(1). A taxpayer may qualify as a real estate professional if (1) more than one half of the personal services performed in all trades or business by the taxpayer are performed in real property trades or businesses in which the taxpayer materially participates; and (2) the taxpayer performs more than 750 hours of services in real property trades or business in which the taxpayer materially participates. IRC § 469(c)(7)(B)(i), (ii). A taxpayer “materially participates” if he or she works on a regular, continuous and substantial basis, and a taxpayer is permitted to establish participation “by any reasonable means.”  Treas. Reg. § 1.469-5T(f)(4).

The only issue in dispute was whether Mr. Chery had performed more than one half of his personal services during 2008 in real property trades or businesses, which meant that he had to spend more than the 2,047 hours that the parties agreed he spent as a U.S. postal inspector. Material participation was not disputed by the Department.

ALJ Determination. The ALJ agreed that Mr. Chery was entitled to be treated as a real estate professional. She found that Mr. Chery participated in his rental activities on a “regular, continuous and substantial basis,” hired no help, and was “clearly involved in the day-to-day management of his rental property in every aspect.” She relied on the “meticulous contemporaneous vehicle log” he maintained, which the ALJ determined contained “more than sufficient supplemental documentation” of Mr. Chery’s hours of participation. She rejected the Department’s challenge to the time Mr. Chery spent traveling to his properties, finding that his travel time was “unequivocally” an “integral” part of the rental property operations. The ALJ distinguished Mr. Chery’s evidence from that found insufficient in Mowafi v. Commissioner  of Inernal  Revenue,  T.C.  Memo  2001- 111 (2011), where the taxpayer relied primarily on trial testimony and noncontemporaneous logs prepared in connection with a tax audit. Mr. Chery had submitted his contemporaneous vehicle log, an electronic calendar, and a contemporaneous compilation of miles driven, expenses and hours spent, and established that many tasks listed  on his calendar entries did not require a trip and therefore did not appear in the vehicle log.

The ALJ therefore found that 180 hours identified in the calendar should have been added to the vehicle log hours of 1,872, totaling 2,052 hours, alone sufficient to exceed the 2,047 hours spent on the postal service job. However, the ALJ also found that the 289 hours he spent on his real estate consulting business, CLC, should be included, despite Mr. Chery’s having failed to properly set forth his CLC activities on a federal Schedule C.  She concluded that Mr. Chery’s real estate consulting activity for CLC should be treated together with his rental activities for the properties he owned as a single activity, and that the vehicle log hours of 1,872, the 180 non-vehicle log hours, and the 289 CLC hours came to well more than the 2,047 hours spent on the postal service job, qualifying Mr. Chery as a real estate professional and allowing him to claim rental losses without limitation.

Additional  Insights.

The IRC contains strict requirements that an individual must meet before being able to claim rental loss deductions. In 2011, a report prepared by the Treasury Inspector General for Tax Administration evaluated the IRS’s audits of individual tax returns with rental real estate activity and recommended increased scrutiny, in the light of public reports of substantial lack of compliance with the rules. There is no indication in the Chery decision that the IRS had audited the taxpayer’s returns, but the facts recited in the decision make clear that the Department, as well as the IRS, is carefully inspecting returns claiming passive rental losses.

Here, the ALJ stressed several times that extensive contemporaneous records were relied upon, and while the federal regulations expressly state that contemporaneous records are not required if the extent of the taxpayer’s participation is established by “other reasonable means,” Treas. Reg. § 1.469-5T(f)(4), there can be no doubt that such records weighed heavily in the taxpayer’s favor.  Also, the ALJ described Mr. Chery as a “well- educated, hard working young man” who “approached the management and operation of his rental properties from  a posture of sophistication and dedication” and noted that his records “reflected a high level of conscientiousness.” It seems clear that the credibility of Mr. Chery as a witness played a large part in his convincing the ALJ of the basis for his position, including the fact that he apparently worked more hours on his real estate ventures than on his day job, for a total number of hours that left little time remaining in the day for anything else.