The real estate professional rules under Internal Revenue Code (IRC) Section 469(c)(7) were instituted in 1993 to afford those who earn their living in real estate trades or businesses the opportunity to deduct losses from their real estate activities.
Under IRC Section 469(c)(2), passive activities include any rental activity except as provided in (7), which provides for the real estate professional exception.
In order to be considered a real estate professional, a taxpayer must meet two separate requirements. First, more than 50% of personal service hours performed by the taxpayer in all trades or businesses must be performed in real property trades or business in which the taxpayer materially participates. In addition, the taxpayer must perform more than 750 hours of personal services during the tax year in real property trades or businesses in which the taxpayer materially participates. A taxpayer can make an election under Regulation 1.469-9(g) to combine real estate activities for the purpose of testing material participation once he or she passes the first two hurdles. For married taxpayers, the 50% and 750 hour tests are satisfied if one spouse individually satisfies the test, however, they cannot combine their hours and pass these tests.
Each year, the real estate professional rules are the subject of several tax court cases. In 2019, one such case was Hairston v Commissioner. Married taxpayers filed their 2014 individual returns claiming to be real estate professionals. The couple owned two residential rental properties that were adjacent to their principal residence in Maryland and deducted a total of $27,488 in losses on their 2014 Form 1040. Upon examination, the Internal Revenue Service (IRS) determined that neither of the taxpayers qualified as a real estate professional, disallowed the losses, and issued a notice of deficiency. The taxpayers petitioned the Tax Court, contending that at least one of them qualified as a real estate professional.
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In all cases, taxpayers bear the burden of proof in substantiating their positions. Here, the taxpayers produced a calendar for each rental property that they indicated showed the hours spent during 2014. The Court found many issues with the quality and timeliness of the taxpayers’ recordkeeping. In a post-trial brief, the taxpayers argued that 170 hours were attributable to Mrs. Hairston, 669 hours were attributable to Mr. Hairston, and 93 were attributable to either of them. The Court decided that they did not satisfy their burden of proof, as their calendars lacked credibility, and they were therefore not deemed real estate professionals. One of the reasons cited for the Court’s decision was that every task on the calendar was recorded as taking at least one hour, including collection of rent, depositing of checks, or paying the mortgage. The Court also took issue with Mr. Hairston’s time spent supervising contractors, including 40 hours spent supervising the painting of the interior of the rental property, stating that “we understand Mr. Hairston, having recently retired, had time on his hands. But we cannot believe that he spent an entire week watching paint dry.”
The Hairston case is a good reminder for taxpayers to make sure to keep detailed, contemporaneous records of their real estate related activities. Courts traditionally look at detailed and contemporaneous records as more reliable in IRS audits, which may help to support the claim that a taxpayer is a real estate professional.
Author: Sara Palovick, CPA | [email protected]
Real Estate Services