Why Real Property?
It is not unusual for the owners of a closely held business to also own a number of real properties. For example, they may own real property that:
- headquarters the business;
- serves as a warehouse for the business;
- serves as parking for a fleet of vehicles used by the business;
- they want to keep out of the hands of a competitor;
- is located in proximity to the business and could be used for future growth;
- is located in a different geographic region into which the business plans to expands; or
- serves as a solid investment for excess cash that was generated through the business.
In most cases, the business will occupy the entire property. If the owners have been well-advised, the property is housed in an LLC (not a corporation) of which they (not the business) are the members, while a different entity holds the business and uses the property pursuant to an arm’s-length lease.
Rental Real Estate = Passive Activity?
In many cases, however, the business is not the sole tenant; in some cases, the business does not use the property at all. In those situations, the owners must be alert to the application of the passive loss rules, and the consequences thereof, as illustrated by a recent decision.
Taxpayer ran an architectural business. During Tax Year, he spent 109 hours providing architectural services to Bank and about 540 hours providing similar services to Construction Co.
During Tax Year, Taxpayer owned and managed two residential rental properties: a single building containing four separate apartments, plus a single-family home. He made weekly trips to the properties to ensure that trash bins were set out for collection, cleaned if necessary, and returned to their storage locations. He also performed minor repairs at the properties, coordinated more substantial repairs with a handyman, communicated with the tenants and collected and deposited rent, maintained insurance policies, purchased materials for the properties as needed, paid bills, and kept books and records of his expenses for tax accounting purposes.
Two of the four tenants moved out during Tax Year. As a result, Taxpayer spent additional time coordinating with them as they vacated the apartments, performed extra repair and maintenance work to ready the apartments for new tenants, placed advertisements listing the apartments for rent, and worked with new tenants as they signed leases and moved into the apartments.
Taxpayer was late paying property taxes and insurance premiums on both rental properties during Tax Year. Consequently, he was obliged to spend time negotiating a property tax installment payment plan, and had to work with his mortgage lender to eliminate redundant insurance coverage on the properties.
Tax Return and IRS’s Determination
Taxpayer timely filed IRS Form 1040, U.S. Individual Income Tax Return, for Tax Year. He reported gross receipts from his architectural business as a sole proprietor – on Schedule C, Profit or Loss from Business – offset by various expenses.
He also attached Schedule E, Supplemental Income and Loss, to his tax return, reporting gross rental income from the two properties, offset by expenses that resulted in a net loss from the rental activity, which Taxpayer reported in computing his taxable income.
The IRS determined that Taxpayer’s rental loss deduction was disallowed under the passive activity loss rules, and assessed a deficiency in Taxpayer’s Federal income tax for Tax Year.
Taxpayer petitioned the Tax Court. The sole issue for decision was whether the loss that Taxpayer reported on Schedule E should be disallowed under the passive activity loss limitations.
The Court began by stating that, as a general rule, the IRS’s determination of a taxpayer’s liability in a notice of deficiency is presumed correct, and the taxpayer bears the burden of proving that the determination is incorrect.
Deductions, the Court continued, are a matter of legislative grace, and the taxpayer generally bears the burden of proving entitlement to any deduction claimed. Specifically, a taxpayer must substantiate any deductions claimed by keeping and producing adequate records that enable the IRS to determine the taxpayer’s correct tax liability.
The Court noted that Taxpayer produced an activity log listing the personal services that he performed in managing the rental properties during Tax Year and the time that he spent providing those services. The activity log indicated that he devoted 765 and 372 hours to the management of the two properties, respectively.
Taxpayer also produced records of his email exchanges with his tenants and mortgage brokers (related to his attempts at refinancing the mortgages on the properties), and numerous receipts from home improvement stores and other vendors related to the management of, and repairs undertaken at, the rental properties.
In determining their taxable income, taxpayers are allowed deductions for certain business and investment expenses. However, the Code generally disallows any deduction for so-called “passive activity” losses.
A passive activity loss is defined as the excess of the aggregate losses from all passive activities for a taxable year over the aggregate income from all passive activities for that year.
A passive activity is any activity that involves the conduct of a trade or business, or an investment activity the expenses of which are deductible as incurred for the production of income, in which the taxpayer does not materially participate.
A passive activity loss may not be used to offset non-passive income (in Taxpayer’s case, the income from his architectural business).
A rental activity generally is treated as a per se passive activity regardless of whether the taxpayer materially participates. The term “rental activity” generally is defined as any activity where payments are principally for the use of tangible property.
The Code provides special rules for taxpayers engaging in real property businesses. Under these rules, the rental activities of a qualifying taxpayer in a real property trade or business – i.e., a “real estate professional” – are not per se passive activities and, if the taxpayer materially participates in the rental real estate activities, these activities are treated as non-passive activities.
A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.
A taxpayer qualifies as a real estate professional during a taxable year if:
- more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and
- the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
“Personal services” means any work performed by an individual in connection with a trade or business.
In accordance with the flush language of the Code, Taxpayer elected to treat all of his interests in rental real estate as one activity for purposes of the special rule applicable to real estate professionals.
The extent of a taxpayer’s participation in an activity, including evidence of the number of hours that they participate in a real property trade or business, may be established by any reasonable means.
Contemporaneous daily time reports, logs, or similar documents are generally not required – though they should certainly recommended – if the extent of such participation may be established by other reasonable means. Reasonable means may include, but are not limited to, the identification of the services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
The Court pointed out that a post-event “ballpark guesstimate” will not suffice to establish the extent of one’s participation.
Although Taxpayer worked about 650 hours providing personal services as an architect during Tax Year, the record, including his activity log and other records, showed that he also spent more than 750 hours providing personal services in connection with the management of the rental properties. Taxpayer also offered credible testimony describing the time and effort that he devoted to both activities during the year. His testimony was largely corroborated with objective evidence, including a rental activity log, receipts for various rental-related expenditures, emails, and other business records.
Considering all the facts and circumstances, the Court found that Taxpayer qualified as a real estate professional during Tax Year, and that his rental real estate activities were regular, continuous, and substantial within the meaning of the passive loss rules.
Thus, the Court concluded, the loss deduction claimed by Taxpayer was not disallowed as a passive loss, and could be applied against Taxpayer’s business income.
Forewarned . . . Means No Surprises
I don’t care for surprises, nor do most business owners, at least insofar as their taxes are concerned.
In order to avoid such surprises, those business owners who also own rental real property that is not related to the owner’s primary business, must be familiar with the limitations imposed by the passive loss rules, and they must be prepared to maintain records of their rental-related activities on a contemporaneous basis.
Although this level of diligence may seem like a chore to the owner, it could provide a commensurate level of certainty as to the tax treatment of the activity and of any losses generated by the activity, not to mention a reduction in the professional fees to be incurred in defending the taxpayer’s return on audit.
 The IRS acknowledged in the notice of deficiency that Taxpayer was entitled to deduct $25,000 of the loss in accordance with the exception prescribed in IRC Sec. 469(i). Under this rule, a taxpayer who “actively” participates in rental real estate activities may deduct up to $25,000 per year for related passive activity losses.
 The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Taxpayer did not contend that his work as an architect constituted a real property trade or business.
 The Court observed that Taxpayer may have exaggerated the number of hours recorded in his rental real estate activity log; for example, the Court disregarded the hours that Taxpayer listed for vehicle maintenance. Nevertheless, the record as a whole showed that Taxpayer spent at least 750 hours managing the rental properties in Tax Year.
 In some cases, it may be possible for the business owner to “group” his primary business activity with his related rental activities, provided the two activities constitute an “appropriate economic unit” (for example, because of interdependencies between them), and the rental activity is “insubstantial” in relation to the business activity, or each owner of the business has the same proportionate interest in the rental activity. In this way, the rental activity may avoid being characterized as passive.