Many people invest in rental real estate as a way to build wealth and invest for the future. However, one negative aspect of real estate investing is that, for many small-time investors, losses incurred in rental real estate cannot be immediately deducted. This is because of the IRS’ rules on passive losses. The U.S. Tax Court recently rejected one taxpayer’s attempt to avoid those passive loss rules and immediately claim real estate losses.
General Rules On Real Estate Losses
Taxpayers are generally allowed immediate deductions for most business and investment expenses incurred during a tax year. However, if the taxpayer is an individual, federal tax law disallows any “passive activity loss” for the taxable year and treats it as a deduction allocable to the same activity for the next taxable year.
In general, a passive activity is any trade or business in which the taxpayer does not materially participate. A taxpayer is treated as materially participating in an activity only if his or her involvement in the operations of the activity is regular, continuous and substantial. Rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates.
There is an exception to the rule that rental activity is per se passive. The rental activities of a “real estate professional” are not subject to that per se rule. A taxpayer qualifies as a real estate professional if: (1) more than one-half of the personal services performed in trades and businesses by the taxpayer during the taxable year 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 during the taxable year in real property trades or businesses in which the taxpayer materially participates.
The Flores Case: The Tax Court Rejects Classification As A “Real Estate Professional”
Edgar and Julia Flores owned a townhome in Illinois, which was 17 miles away from their primary residence. They rented the property (or held the property out for rent) throughout 2011. The townhome was their only rental real estate in 2011. Edgar managed, renovated and repaired the property during 2011. He performed all of the work himself.
During 2011, Julia worked full time (at least 1,800 hours) for a manufacturer. She was also the treasurer for a local youth football league. In addition to his real estate duties, Edgar worked at least 1,294 hours for a pavement striping company in 2011.
The Flores’ rental property incurred a net loss in 2011. The Flores’ return reported $15,648 of rental income and $26,138 of expenses for the property. Rather than hold these losses and use them against rental income in later years, Julia and Edgar Flores wanted to use the losses in 2011. So, they claimed that Edgar was a “real estate professional.”
Because Edgar performed renovations and repairs on the property himself, the rental property likely did not feel like a passive activity to the Flores family. Unfortunately, there can be a disconnect between what feels like a passive activity and what federal tax law specifies is a passive activity. As noted above, one part of the real estate professional test requires that more than one-half of the personal services performed in a trade or business by a taxpayer be performed in a real property trade or business in which the taxpayer materially participates. Mr. Flores spent at least 1,294 hours at work for the pavement striping business. So, to prevail on his argument, he had to show that he spent at least 1,295 hours working on the rental property.
Mr. Flores was able to produce a calendar that identified the dates and times that he contended he spent working on the rental property during 2011. He also produced a summary that computed, on the basis of the calendar, the total number of hours that he worked. But, according to his own calendar and summary, he spent a total of 799 hours working on the property. This was less than the 1,294 he needed.
Mr. Flores then testified about a second calendar that he contended identified additional hours that were not included in the first calendar. The Tax Court was not convinced by his testimony, finding that this testimony about the second calendar was inconsistent with the first calendar. Ultimately, Mr. Flores could not document, to the satisfaction of the Tax Court, that he spent more time working on the rental property than he spent as an employee of the pavement striping company.
Therefore, the Tax Court held that Edgar did not qualify as a real estate professional for 2011. The Tax Court disallowed the Flores’ 2011 loss on their rental property.
This case illustrates the importance of a) understanding how tax laws can impact your business or investment activity; and b) keeping records that will document the tax position you are trying to take. A little planning and documentation here may have led to a better result.
If you are contemplating a new business or investment, feel free to contact a member of the McGrath North Tax Group to discuss the tax implications of that business or investment. You should also feel free to contact us if the IRS or Nebraska Department of Revenue is questioning a position you have taken on a return. We are happy to work with you to obtain the best possible outcome.