Tax Court Corner: Couple Prevails in Passive Activity Case
We all know the passive activity loss (PAL) rules when it comes to rental properties, but in the case of Joseph D. Moon, et al. v. Commissioner, the US Tax Court recently issued a summary opinion that could change the way you look at PAL.
In summary, all losses on rental properties are passive and can only be claimed by the taxpayer if they meet certain adjusted gross income limitations. In general, they are considered to have materially participated in the activity just by owning the property; however, material participation is not enough to make the losses active.
Actively participating in the activity requires spending up to 750 hours of time working on the rental property for the losses to be considered nonpassive. Also, being deemed a real-estate professional would make the losses nonpassive.
During the years at issue, Joseph Moon was a full-time airline pilot for UPS Inc. His wife, Darsey Moon, was a part-time ski instructor who worked for 199.25 hours, 53.25 hours, 90.75 hours, and 96.25 hours during the 2008, 2009, 2010, and 2011 tax years, respectively.
The Moons owned three rental properties during the years in question. All three properties were single-family residences. They disposed of one of the properties near the end of 2009.
Darsey Moon personally oversaw all of the rental activities and managed the properties, including any repairs and renovations, only receiving some help from her husband, as he was employed full-time as a pilot for UPS. Darsey had more time to manage the properties because she was employed only part-time as a ski instructor. What is important here is that she maintained contemporaneous logs of the time she spent involved with the rental properties.
When the IRS examined the returns, she had condensed the logs into activity summaries to support their claimed deductions. Her activity summaries documented that she performed 1,002.5 hours of service for 2008, 1,227.5 hours for 2009, 834.5 hours for 2010, and 863.5 hours for 2011, with respect to her rental real-estate activities.
At the audit, the IRS determined, through notices of deficiency, that the Moons’ claimed loss deductions for the years at issue were subject to Code Section 469 (PAL limitations). The taxpayers did what was within their rights, which is seeking relief in the Tax Court.
Somehow, this matter was actually heard in court because the Tax Court treated allegations in the IRS’s amended answer and statements in its pretrial memorandum as a concession that the taxpayer’s rental real-estate activities were not passive for 2009.
In its pretrial memorandum, the IRS asserted that the hours Darsey spent on business and tax issues in 2008, 2010, and 2011 were investor hours and should be excluded from the number of hours she spent in real property trades or businesses for purposes of determining whether the activities were passive. The IRS also asserted that the hours she spent in 2008 on one of the properties should be excluded because she did not materially participate in that property. The IRS did not present arguments on these points in its brief. Accordingly, the Tax Court concluded that the IRS had abandoned these issues.
Let this be a warning to you. The IRS, in court, will pick the bigger of the battles and fight them. You should do the same when representing a client. I represent every case believing I will give this up, but I am not willing to give up the bigger issue.
Because the IRS did not assert that Darsey failed to materially participate in any of her real property trades or businesses during any of the years at issue, the court treated this omission as a concession that she did materially participate in all of her real property trades or businesses during the years at issue.
In short, in this pleading, the government’s attorney either mishandled the case, or the IRS was actually conceding the argument.
In this case, the court noted that the IRS asserted for the first time, in its brief, that the amount of time Darsey spent traveling from property to property should not be counted toward her participation activity. The IRS made another mistake by not including how many hours it was disputing, and neither party gave any evidence on the issue.
In the 2013 Tax Court case Suriel vs. Commissioner, the court held the position that issues being raised for the first time on a brief would not be considered in the ruling, when doing so would prevent the opposing party from presenting evidence if the issue had been timely raised. Basically, a Federal Rules of Evidence issue.
The court ruled that Darsey Moon both actively and materially participated in the activities, thus deeming her a real-estate professional. It ruled against the IRS’s assertion that the taxpayer had PAL. Further, the court rejected the IRS’s contention that Darsey’s activity summaries were not reliable because the time logs she kept weren’t prepared contemporaneously and she overstated the time she spent on the activity.
After considering the taxpayer’s own testimony and review of the records, the court concluded that the logs were indeed prepared contemporaneously and they were not overstated.
In short, the taxpayer won the case because the court deemed her a real-estate professional.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...