The tax limits generally deductions for passive activity losses (PALs) from real estate unless you can qualify as a real estate professional. To measure up, you must be able to prove that you spent enough time on your real estate activities. In a new case, Sezonov, TC Memo 2022-40, 4/20/22, the taxpayer came up short, even with the Tax Court giving him the benefit of the doubt.
Background: As a general rule, investors in activities such as real estate in which they don’t materially participate can only take deductions up to the amount of their “passive income” for the year. Thus, they can’t claim any annual losses, although there’s a limited PAL write-off allowed for real estate investors who are “active participants.” Normally, you can use up to $25,000 of loss to offset non-passive income. This $25,000 offset is phased out for a modified adjusted gross income (MAGI) between $100,000 and $150,000 of MAGI.
However, if your real estate activities rise to the level of being a real estate professional, you can deduct a loss against non-passive income, just like any other business. There are two key requirements for qualifying as a real estate professional.
1. More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
2. You must spend more than 750 hours on your real property trades or businesses.
As long as you satisfy this two-part test, real estate activities in which you materially participate aren’t treated as passive activities. Because the IRS often contests these types of claims, be prepared to offer reasonable proof.
New case: The taxpayer, a resident of Ohio, was the only member of a limited liability company (LLC) through which he operated a wholesale HVAC business. He ran the business by himself full time with no employees throughout 2013 and 2014.
In 2013, the business purchased two rental properties in Florida. The taxpayer and his wife rented out both properties during the two tax years in question (after temporarily leasing one property to its former owner) while they continued to live in Ohio.
The taxpayer’s wife advertised the Florida rental properties and communicated with renters and prospective renters by email. In between rentals, she would clean and prepare for the next renter or hire a cleaning service for the job. The taxpayer assisted by responding to emails, as well as performing maintenance and repairs for the properties, but his wife was responsible for the day-to-day management.
The couple didn’t maintain contemporaneous records of the hours that they worked on their Florida rental properties. However, while their case was pending before the Tax Court, the taxpayer’s wife created time logs estimating the time that both had had worked on the properties.
After the taxpayer deducted the entire loss from the Florida real estate rentals for each year, the IRS contested the matter and assessed a deficiency.
Tax outcome: While the couple’s recordkeeping was shoddy, at best, it really didn’t matter. Even if the Tax Court accepted the logs, it noted that they did not total up anywhere close to 750 hours. As a result, the loss deductions were denied.
Moral of the story: To qualify as a real estate professional, you must “do the time” and be able to prove it through contemporaneous recordkeeping. Be diligent: The IRS is in the lookout for exaggerated claims by people with other full-time jobs.