Deconstructing Miller (not the bland beer made popular by Bubba Smith and Dick Butkus, the Tax Court case)
(Ed note: Ok, I’ll admit it…that clumsytitle was just a way for me to sneak the name “Butkus” into a post). Funny stuff.
What follows is a deconstruction of the Tax Court’s decision last week in Miller v. Commissioner, [i] a case involving a purported real estate professional that we here at Double Taxation feel has some important implications. Bear with us.
A few weeks ago, we took a look at Harnett v Commissioner, another in the long line of cases analyzing whether a taxpayer qualifies as a ”real estate professional” under Section 469(c)(7). Our analysis focused on the progress the Tax Court has seemingly made in applying the “750 hour test,”oneof thetwo tests a taxpayer mustsatisfyin order to meet the definition of a real estate professional, thus removing the taxpayer’s rental activities from de facto passive classification.
As a reminder, the two tests are:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the year must be performed in real property trades or businesses in which the taxpayer materially participates.
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
With regards to the 750 hour requirement, we stated in our analysis of Harnettthat the Tax Court had erred in previous decisions [ii] by requiring a taxpayer who failed to elect to aggregate his rental activities to spend more than 750 hours in each rental activity.
What follows is the Tax Court’s rationale for its decision in Jahina:
Because petitioners did not properly elect to treat the rental properties as a single activity, they cannot group them. As an additional consequence of the failure to elect, Mrs. Jahina must qualify as a real estate professional with respect to each property separately in order to avoid a determination that the rental activities were per se passive…Thus, to hold in petitioners’ favor, the Court must find: (1) That more than one-half of Mrs. Jahina’s personal services during the taxable year were performed in each rental property activity in which a loss deduction is claimed, and (2) that Mrs. Jahina performed more than 750 hours of services during the taxable year on each of the claimed properties.
The evidence fails to establish that Mrs. Jahina was a real estate professional with respect to each of the rental properties considered separately.The requirements of section 469(c)(7)(B) were not met with respect to any of the rental properties individually. During all of 1996 and until August 1997, Mrs. Jahina had a full-time job with a standard work requirement of 1,800 hours per year. During the latter months of 1997, she had a part-time job. She did not work on any one of these properties more than she worked on her wage jobs. Further, she did not satisfy the 750-hour statutory minimum for any one of them.
Now, we’ve never agreed with that approach. To the contrary, we believe that even when a taxpayer fails to make the election to aggregate rental properties, they should only be required to satisfy the 750-hour test on an aggregate basis through a two-step process: 1) First identifying the activities in which the taxpayer materially participates, and 2) Aggregating the hours spent on those activities to see if they exceed 750.
We were particularly encouraged by Harnett, because the Tax Court seemed to embrace this line of thinking.In determining whether Harnett was a real estate professional,the Tax Court combined the hours spent by the taxpayer on only those properties in which the taxpayer materially participated, without making mention of an election to aggregate the activities.
This brings us to the Tax Court’s decision this week in Miller v. Commissioner, another real estate professional case, and one which provides further evidence that the failure to elect to aggregate activities is not fatal to the taxpayer.
In Miller, the taxpayer was a boat pilot and the owner of six rental properties. Miller deducted the losses from his rental activities without limitation, taking the position that he was a real estate professional. Miller, however, failed to elect to aggregate his six rental properties.
Using the rationale from the Jahina decision, the Tax Court would have required Miller to 1) spend more time on each of his rental properties than he spent on his full-time gig as a boat pilot, and 2) spend more than 750 hours on each of the six properties in order to qualify as a real estate professional. But that’s not how things went down.
The court quickly determined that Miller met the first (more than half) requirement of the real estate professional test, stating
We find that Mr. Miller has established that he spent more than 750 hours performing significant construction work as a contractor and on his rental real estate activities. We findthat Mr. Miller spent more time on his construction work and rental properties than he did piloting vessels in the years at issue. Having found that Mr. Miller is a qualified real estate professional, we now consider whether petitioners materially participated in their rental activities. For this purpose, each interest in rental real estate is treated as a separate rental real estate activity unless the qualifying taxpayer makes an election to treat all interests as a single activity. Petitioners did not make such an election.
This quote is fascinating for at leastfour reasons:
1. Clearly, the Tax Court did not take the same approach as it did in Jahina, where when the taxpayer failed to elect to aggregate its rental activities, the court required “that more than one-half of Mrs. Jahina’s personal services during the taxable year were performed in each rental property activity in which a loss deduction is claimed.”
In Miller, the court simply added up the hours spent on the taxpayer’s real estate activities and compared it to his hours spent piloting his boat, and concluded that he spent more time on the former. More importantly, it did this without Miller having made an election to aggregate his rental activities, an approach I believe is in line with the intent of the law, if not the specific language.
2. If all the court was doing in the quoted paragraph was determining if Miller spent more than half his time on real estate activities for the year, why did it state that Miller spent more than 750 hours on his activities? This seems irrelevant if the court was not analyzing the 750-hour test yet, which it wasn’t (or at least shouldn’t have been).
3. How can the court proclaim they “found that Mr. Miller is a qualified real estate professional” without first determining if Miller spent 750 hours on the rental activities in which he materially participated? Doesn’t Section 469(c)(7) require a taxpayer to meet both prongs of the test to meet the definition of a real estate professional?
4. Doesn’t the first (more than half) test require that the taxpayer spend more than half his time on rental activities in which he materially participated? It would follow, then, that the court would have to determine if Miller materially participated in his activities before it could hold that he met the more than half test. For example, what if Miller spent more than half of his year working on his rental activities, but did not actually meet the material participation test for any of the activities? Wouldn’t he fail the more than half test?
So many questions, but let’s move on…
The Tax Court next set out to determine whether Miller materially participated in his six separate rental activities. The court looked to the 100-hour test of Treas. Reg. §1.469-5T [iii] and held that Miller met the test for two of his properties but not the remaining four.
This is where things get even more interesting. The court stated:
We hold that petitioners materially participated in the [two rental properties] and the deductions attributable to those activities are not subject to limitation under section 469. Petitioners have not shown, however, that they participated in [the other four rental properties] for over 100 hours per year for the relevant years. We sustain respondent’s disallowance of losses with respect to the [four rental properties].
Deconstructing Miller further, this paragraph is particularly meaningful in two ways:
1. Noticeably absent from the court’s analysis is any mention of whether Miller spent more than 750 hours on the two rental properties in which he materially participated. Should this just be assumed? We know he materially participated in those two activities, but did he spend more than 750 hours in the activities, either combined (as we would argue) or separately (as Jahina held), as Section 468(c)(7) requires?
Now, the court mentioned in its earlier quote that Miller spent more than 750 hours on his rental activities, but they didn’t isolate that only to those activities in which he materially participated. It’s almost like the Tax Court has gone to the opposite extreme: instead of requiring the taxpayer to spend more than 750 hours on each property if an election to aggregate activities is not made, it appears in Miller the court simply looked to whether the taxpayer spent 750 hours total on his rental activities, and then allowed deductions for only those activities in which Miller materially participated, the reverse of the steps we infer from our reading of the Code.
2. Knowing now that Miller only materially participated in two of the six rental properties, did his hours spent on those two properties exceed his hours spent on his boat piloting activities, thus passing the “more than half test?” Isn’t that is what’s required under the first test of Section 469(c)(7).
If you’re confused by this…well, you’re not alone. Clearly, we don’t understand much about Miller, even after a thorough deconstruction. But one thing we do know is that the taxpayer failed to elect to aggregate his six rental activities, and the court still held that he was a real estate professional with regards to two of the activities, requiring only that he materially participate in the activities, not that he spend 750 hours in each activity. This is a step in the right direction to satisfying the intent of the real estate professional rules: to remove de facto passive status from those that spend the majority of their time materially participating in real estate activities.
