The United States Tax Court recently issued an opinion which provides a good analysis of the passive activity loss limitations of Internal Revenue Code § 469 and their applicability to those involved in managing rental real estate. In Birdsong v. Commissioner, T.C. Memo 2018-148 (Sept. 10, 2018), the petitioners, husband and wife, were the owners of two rental real estate properties consisting of four and five rental units, respectively. The husband worked full time as an emergency physician. While the wife was not formally employed, she divided her time between caring for the couples’ children and managing the rental properties.
In connection with her management of the rental properties, the wife’s tasks included, among other things, cleaning common areas, collecting coins from washing machines, performing repairs, communicating with tenants, collecting and depositing rent, maintaining insurance policies, inspecting units, preparing units for rental, screening potential tenants, and processing rental applications. She maintained spreadsheets detailing her activities which indicated she worked more than 1,000 hours in 2014 in connection with the rental properties.
Petitioners hired an accountant to prepare their 2014 tax return, and the accountant reported a loss for their rental real estate activities as though the wife qualified as a “real estate professional.” On September 12, 2016, the IRS issued petitioners a notice of deficiency for 2014, disallowing their 2014 rental real estate loss in excess of the section 469 passive activity loss limitations. Petitioners then filed a petition with the Tax Court.
The Tax Court began its analysis by noting that while taxpayers are allowed deductions for certain business and investment expenses pursuant to sections 162 and 212, section 469 generally disallows any passive activity loss for the tax year. See I.R.C. § 469(a). A passive activity is any trade of business in which the taxpayer does not materially participate, and a passive activity loss is defined as the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for such year. I.R.C. §§ 469(c)(1), 469(d)(1).
As noted by the Tax Court, a rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates. See I.R.C. § 469(c)(2). However, section 469 provides an exception for real estate professionals. Pursuant to section 469(c)(7), the rental activities of a taxpayer engaged in the real property business, i.e. real estate professionals, are not per se passive activities but are treated as a trade or business subject to the material participation requirements of section 469(c)(1). See Income Tax Reg. 1.469-9(e)(1).
To qualify as a real estate professional that is not engaged in a passive activity, a taxpayer must meet two requirements:
- 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
- such taxpayer performs more than 750 hours of services during the taxable year in real property trades or business in which the taxpayer materially participates.
The IRS conceded that the wife satisfied the first prong of this test because she was not otherwise employed in 2014. Thus, the only issue before the Tax Court was whether the wife satisfied the 750-hour requirement under the second prong of the real estate professionals test.
The IRS argued that the spreadsheets produced by the wife did not establish she met the 750-hour requirements because they were not prepared contemporaneously and were inaccurate. The Tax Court disagreed, holding that petitioners provided credible testimony at trial about the wife’s active and extensive management of the couple’s rental properties, and further provided detailed spreadsheets that reflected the wife’s rental management activities exceeded the required 750 hours. Based on these findings, the Tax Court concluded the wife, pursuant to section 469(c), materially participated and is a real estate professional. Accordingly, the Tax Court held the petitioners’ loss attributable to their rental real estate was not limited by the passive activity loss rules of section 469.