There’s a big tax difference between taxpayers who are treated as real estate professionals under the tax law from those who are considered mere passive investors. However, as evidenced by a new case, Pourmirzaie, TC Memo 2018-26, 3/8/18, you must show that you’ve put in the time to qualify as a real estate pro.
Generally, investors in activities such as real estate in which they do not materially participate can only take deductions up to the amount of their “passive income” for the year. Thus, they can’t claim annual losses (although there’s a limited write-off allowed for real estate investors subject to an income phase-out).
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:
- 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.
- You must spend more than 750 hours on your real property trades or businesses.
If you satisfy this two-part test, real estate activities in which you materially participate aren’t treated as passive activities.
Facts: For a three-year period, a couple claimed substantial losses stemming from five rental properties, including a four-unit residential property in San Jose, California; a single-family condominium in San Diego, California; a single-family residence in Tucson, Arizona; a single-family condominium in Bremerton, Washington; and a single-family residence in Discovery Bay, California. In addition, for one year they claimed a loss from a Marriott timeshare. The following were also factors in the case:
- The taxpayers shared responsibility for management of the San Jose property. They did not keep an office at the property nor store tools there. Plus, they didn’t keep any contemporaneous records of the time they spent at the property.
- The taxpayers also shared responsibility for management of the San Diego property. But at trial the wife could not remember specifically what types of management activities she performed there beyond visiting the property to prepare it for, and to meet, new tenants.
- The couple didn’t directly manage the Tucson property. Instead, they hired a property manager, with whom the wife testified that she communicated with only sporadically.
- The couple dealt with the tenants at the Bremerton property by telephone, although the wife could not recall how much time she spent on the telephone with tenants.
- The taxpayers managed the Discovery Bay property themselves. There was one tenant during the years in question. The wife dealt with her primarily by telephone
- The taxpayers offered no evidence for the Marriott timeshare.
After examining the facts, the Tax Court noted that the taxpayers did not keep contemporaneous records of the time spent in their real estate activities. They merely offered calendars that were prepared from the wife’s memory and her testimony did not advance their position. Entries in the calendar were vague, such as "paperwork” and “bill paying."
Furthermore, the Court commented that the couple did not keep an office or tools at the San Jose property, despite their claims that they spent substantial time there. Finally, the Court observed that the taxpayers claimed to have spent time working at one of their West Coast properties, while a bank statement showed them making food and other purchases in New York, Florida and Pennsylvania.
Bottom line: The taxpayers aren’t real estate professionals. The deductions for their passive activity losses were denied.
Advise your clients who participate in real estate activities to keep detailed records of their comings and goings. The documentation may be able to help salvage valuable tax losses.
About Ken Berry
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a wide variety of newsletters, magazines, and other periodicals.