Here are some IRS court cases featuring real estate investors that show how important tax documentation and preparation are to protect you from huge penalties.
Real estate activities are considered passive by default. Passive losses, of course, may generally only offset passive income. Unless that is, you qualify as a “real estate professional” under Section 469(c)(7), in which case you can deduct rental losses in full against nonpassive income.
In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B). The taxpayer must satisfy both of the following tests:
• More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates.
• Such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
Furthermore, Section 469(c)(7)(A)(ii) provides that each interest owned by the taxpayer in rental real estate will be treated as a separate activity unless the taxpayer makes an election to treat all rental real estate activities as a single activity.
CASES
Harnett v. Commissioner, T.C. Memo 2011-191
In this case, the taxpayer owned several properties. He failed to meet the 750 hour test and did not qualify as a real estate professional because the taxpayer could not prove the hours test was met with a detailed log, and the court did not find his testimony credible.
Analysis of Petitioner’s Claimed Hours of Participation Petitioner did not maintain a contemporaneous log of time spent participating in his real estate activities. In 2008, in preparation for the respondent’s audit, he attempted to reconstruct the time he spent in his real estate activities. He claims to- 17 – have spent months going through his records to arrive at these reconstructed estimates, but petitioners have not demonstrated the evidentiary basis or methodology for these reconstructions.
At trial, the petitioner testified that on the basis of these econstructions he estimated spending 1,270 hours managing his real estate properties in 2003, 1,421 hours in 2004, and 1,648 hours in 2005. As discussed in more detail below, the contemporaneous records that petitioners have offered into evidence do not credibly support these estimates.
We conclude and hold that petitioners have failed to establish that for any year at issue petitioner meets the 750- hour requirement to qualify as a real estate professional forpurposes of section 469(c)(7). Consequently, we sustain respondent’s determination that the losses at issue are In the light of this holding, it is unnecessary to decide
whether petitioner spent more than 50 percent of his time in real estate trades or businesses or whether he materially participated in them. attributable to per se passive activities and are subject to the section 469 limitations. Read the full case at http://www.ustaxcourt.gov/InOpHistoric/harnett.TCM.WPD.pdf
TOM AND NANCY MILLER, Petitioners v. COMMISSIONER OF INTERNAL REVENUE
In A recent case of Tom and Nancy Miller v the Internal Revenue, it was established that Mr Miller (despite having a full-time job with a tugboat company) should be classed as a real estate professional based on documentation and the number of hours logged in real estate activity. The findings showed that Mr Miller:
• Established that he spent more than 750 hours performing significant construction work as a contractor and on his rental real estate activities.
• He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent, and performing maintenance work at rental properties.
• Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses.
Petitioners state in their petition that they acted with reasonable cause and in good faith, and we so find. Petitioners prevailed on the threshold question of whether Mr. Miller
qualifies as a real estate professional. They also prevailed on the question of whether they materially participated with respect to two of their rental properties. As for the remaining properties, petitioners provided evidence and gave credible testimony but simply failed to meet their burden of proof. Nevertheless, petitioners provided extensive records of their rental real estate activities, including contemporaneous
timesheets. We find that petitioners acted with reasonable cause and in good faith in claiming rental real estate losses for the years at issue. Accordingly, we decline to impose a penalty upon petitioners.
You can see the full court findings at http://www.bradfordtaxinstitute.com/Endnotes/TC_Memo_2011-219.pdf
ANDREW ROQUE BOSQUE AND ALMA BOSQUE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE
In this case, the petitioners could not prove they spent the necessary 750 hours per year on real estate business due to a lack of appropriate documentation. As a result, they were disallowed the deductions they had claimed on their tax return.
Rental or Lease of Business Property – Petitioners claimed on their 2006 ACI Schedule C a deduction of $14,500 for the rental or lease of business property.
Respondent disallowed the deduction after petitioners failed to provide substantiation. At trial petitioners admitted to having no document On the basis of the record, we conclude that petitioners have failed to show that Mr. Bosque meets the 750-hour service performance requirement of section 469(c)(7)(B)(ii) for the years in issue. Because petitioners have failed to show that Mr. Bosque meets the 750-hour service performance requirement, we hold that he is not a real estate professional for purposes of section 469(c)(7) and that petitioners’ rental real estate activities must therefore be treated as a passive activity under section 469(c)(2).
Read more on this case at http://www.ustaxcourt.gov/InOpHistoric/bosque.TCM.WPD.pdf
Shri G. and Sudha Agarwal v. Commissioner of Internal Revenue
• Mr. Agarwal worked full-time as an engineer
• Mrs. Agarwal worked as a licensed real estate salesperson
• The couple owned two rental properties which Mrs. Agarwal managed
• The rental property expenses exceeded the income so a loss was generated
• The Agarwals used the loss from their rental activity to offset other income
• The IRS disallowed the deduction of the rental loss as they said the rental properties were a “passive” activity thereby only allowing the loss to be deducted in an amount not to exceed the total passive income.
Because petitioners concede that they are not entitled to certain deductions, see supra note 1, the Court finds that respondent has met his burden of production and that petitioners were negligent. Petitioners did not establish a defense for their noncompliance with the Code’s requirements. See sec. 6001 (requiring taxpayers to keep records sufficient to establish the amounts of the items required to be shown on their Federal income tax returns).
Read more on this case at http://ustaxcourt.gov/InOpHistoric/Agarwal.SUM.WPD.pdf
Recent questions from my blog:
QUESTION: In 2005 I entered into a partnership with my brother and a couple of friends. We purchased a single family house to rent out. We (over)paid around $127,000 for the house. The property is titled in my brother’s name, as is the mortgage on the property, with a current balance of $102,000. A few years back, as the partnership began to lose money, I bought out two of the partners. I now own about an 80% interest in the partnership.
I would like to buy out my brother’s interest so that I can eventually either sell the house utilizing a 1031 exchange or re-finance the house at current low interest rates (I can qualify for a conventional mortgage). I don’t want to sell the house out of the partnership and get stuck paying depreciation recapture. The house will sell for $130k – $135k. In order to do a 1031 exchange or re-finance the house, I need it to be deeded in my name. Can I buy my brother’s share of the partnership and then have the partnership deed the house over to me without triggering any tax consequences? Will the partnership (a general partnership, we never filed formation documents with the secretary of state) cease to exist if I buy out my brother’s interest? Will there be some seasoning period required, or should I be able to re-fi right away if I acquire 100% of the partnership?
ANSWER: The partnership can certainly sell relinquished property held in the entity’s name and then purchase like-kind replacement property to be held by the same entity and still qualify for 1031 Exchange treatment. So even if it is owned just by you or you and your brother, you can still do it in the name of the LLC. Now if you need to refinance then you would need to deed it out of the LLC back into your name.
QUESTION: I had a new water heater installed in the rental (before I placed the rental in service if that matters). Do I have to depreciate the water heater like I would a kitchen appliance, or is it okay to treat it as a repair and add it to the property’s basis?
ANSWER: If the old water heater was not working then you can treat it as a repair. Another alternative is to treat it as a fixture and then elect Section 179 to expense it all in the first year.
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. You can get more information at WealthBuildingPlan
