The Tax Court has held that a taxpayer, who owned over 28 rental apartments and who also was engaged as a full-time research associate for a corporation, wasn’t a real estate professional for purposes of the passive activity loss (PAL) rules. As a result, he couldn’t currently use losses from the rental activities to offset his compensation from the corporation and other income.
Observation: This case illustrates how difficult it is for a taxpayer to qualify as a real estate professional for purposes of the PAL rules and the necessity of taking steps to document the extent of one’s required participation in that activity.
Background. Losses from passive activities may only be used to offset passive activity income (which doesn’t include portfolio income). Thus, such losses can’t be used to offset income from, for example, compensation, interest or dividends. Any losses that are unused in a tax year because of this rule are carried forward to the following year(s) until used, or until the taxpayer disposes of the interest in the activity (or substantially all of the activity) in a taxable transaction.
The PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. In general, any rental activity is per se a passive activity regardless of the taxpayer’s participation in the activity. However, there are an exceptions to the per se rule for: (a) real estate professionals; and (b) up to $25,000 of losses, subject to an adjusted gross income (AGI) phaseout.
The per se rule for rental activities doesn’t apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if:
- More than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and
- He performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates. For taxpayers filing a joint return, either spouse may separately satisfy the real estate professional requirements.
If a taxpayer is a qualifying real estate professional, the PAL rules generally are applied as if each interest of the taxpayer in real estate were a separate activity. But the taxpayer may elect to treat all his interests in rental real estate as one activity. The election is made by filing a statement with the taxpayer’s original income tax return for the tax year. This statement must contain a declaration that the taxpayer is a qualifying taxpayer for the tax year and is making the election under Code Sec. 469(c)(7)(A).
Facts. During 2008, the taxpayer, Mohammad Hassanipour, was employed full time as a research associate for Geron Corp. He was expected to work 40 hours per week, but his time was not monitored. He sometimes worked weekends to compensate for time off during the week. He signed and submitted to Geron Corp. timesheets for each month in 2008 on which he reported a total of 1,936 hours at 8 hours per day worked that year, not including paid vacation days or holidays.
During 2008, Hassinpour owned 28 rental apartment units in 7 fourplex buildings in Vallejo, California, and he had a 50% interest in a single-family residence in Lake Tahoe, California. He performed various duties in relation to the rental properties including repairs, administrative tasks, communicating with tenants, researching landlord/tenant law, preparing tax returns, and other management activities. The co-owner collected rents and paid bills with respect to the Lake Tahoe property.
On his joint 2008 Form 1040, Hassanipour and his wife reported combined wages of $239,037 and claimed net rental losses of $120,540. They did not elect to aggregate all interests in rental real estate as a single rental real estate activity for 2008. Hassanipour prepared the 2008 tax return using a computer software program.
IRS disallowed the claimed rental losses as Code Sec. 469 passive activity losses.
Hassanipour claimed before and during trial that his hours spent on his rental activities exceeded his time spent working for Geron Corp. He claimed that he worked only 32 hours per week for Geron Corp. for 48 weeks, or a total of 1,536 hours (sometimes claimed to be amended to 35 hours per week, or a total of 1,610 hours). In an attempt to prove his hours spent on rental activities related to the Vallejo apartments, he presented estimates, summaries, and a generic (not dated 2008) calendar copyrighted in 2009 but allegedly kept contemporaneously on dates commencing Dec. 31, 2007. He recorded 1,182.9 total hours on the calendar. He did not keep a contemporaneous record of time spent in relation to the Lake Tahoe property but estimated that he spent 150 to 200 hours in relation to that property and over 500 hours performing tasks not reflected in his calendar.
Taxpayer wasn’t a real estate professional. The parties agreed that the decisive issue was whether Hassanipour spent more hours on his rental activities than he did in his employment with Geron Corp. The Tax Court observed that, in arguing that he was a real estate professional and materially participated in his rental real estate activity, Hassanipour testified that he worked only 32 hours per week, later adjusted to 35 hours per week, for Geron Corp. But the Tax Court said that this testimony was contradicted by the monthly timesheets he signed and submitted to Geron Corp. during 2008.
Hassanipour also relied on estimates based on recollections of events that had taken place several years before and on his questionable calendar that appears, contrary to his testimony, to have been reconstructed rather than contemporaneous. The Tax Court stressed that the taxpayer generally bears the burden of proving entitlement to any deductions claimed. This burden may shift to IRS if the taxpayer introduces credible evidence with respect to any relevant factual issue and meets other conditions, including maintaining required records.
The Tax Court concluded that the Hassanipours did not establish their compliance with Code Sec. 7491(a)(1) and thus they bore the burden of proof. The Tax Court concluded that they did not meet this burden. It rejected Hassanipour’s testimony because of the many indicia of unreliability. His testimony was undermined by the records of his employer, by his questionable claims about the contemporaneous calendar, and by the vagueness and inherent improbability of his estimates. Some of the estimates that he sought to add to the hours recorded in the calendar duplicated tasks or time recorded in the calendar. He did not adequately explain the inconsistencies in his evidence, arguing, erroneously, that IRS had the burden of showing, for example, that a calendar copyrighted in 2009 would not have been available in 2008 (or in 2007, the year of the first allegedly contemporaneous entry).
There also was no evidence of the time the co-owner of the Lake Tahoe property spent collecting rents and paying bills. On consideration of the entire record, the Tax Court found Hassanipour’s reconstruction reducing the hours worked at Geron Corp. and increasing the hours devoted to rental activities to not be credible. Because it was not persuaded that he spent more time on any or all of his rental activities in 2008 than he spent working for Geron Corp., the Court determined that he was not a real estate professional. His rental activities, therefore, were per se passive, and he could not offset the losses against his and his wife’s other income.
Douglas Rutherford, CPA, CGMA
© 2013 Douglas Rutherford, CPA, CGMA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.
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