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I ndividuals who participate in passive activities may be limited in the amount of losses and credits that they may claim on their income tax returns. Under Temp. Regs. Sec. 1.469-1T(e)(1), an activity is classified as passive if the activity is (1) a trade or business activity in which the taxpayer does not materially participate during the year or (2) a rental activity.
Income and losses arising from any rental activity are generally considered passive. 1 One exception to this rule applies to real estate professionals: "If the taxpayer qualifies as a real estate professional, the taxpayer's rental real estate activity escapes the per se rule otherwise applicable to rental activity." 2
A taxpayer will be considered a real estate professional if (1) more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates and (2) 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. 3
Although the Code does not refer to individuals meeting this test as real estate professionals, various IRS regulations and publications 4 and the Tax Court 5 refer to the taxpayers in real property businesses who meet the stipulated statutory requirements as real estate professionals.
The passive activity rules limit the amount that certain taxpayers 6 may deduct or claim as a credit arising from a passive activity. A taxpayer is allowed to deduct passive activity losses only to the extent of the taxpayer's passive activity income arising from all passive activities. 7 A taxpayer can use tax credits arising from passive activities during the current tax year only to the extent of the taxpayer's regular tax liability arising from the taxpayer's passive activities during that year. 8 The excess of the passive activity loss over the taxpayer's passive activity income, plus the disallowed passive activity credit, is treated as a deduction or credit in the next year. 9 A suspended passive loss can offset income from an activity in the following year even if the activity is no longer treated as passive. 10 When a taxpayer disposes of his or her entire interest in the passive activity, he or she generally will be allowed to claim the disallowed passive activity loss. 11
A taxpayer may be able to avoid certain taxes by being classified as a real estate professional. Income arising from "rentals from real estate" is excluded from the definition of self-employment income for the purpose of the self-employment tax. 12 Additionally, the Sec. 1411 tax on net investment income does not apply under a safe-harbor provision for real estate professionals who meet certain criteria.
For tax years beginning in 2013 and later, a 3.8% tax 13 is imposed on the net investment income of taxpayers whose modified adjusted gross income (MAGI) 14 exceeds certain statutory amounts. A married couple who file a joint income tax return and whose MAGI is greater than $250,000, and a married individual filing separately whose MAGI is greater than $125,000, will be subjected to this tax if they have net investment income. In all other cases, individuals with MAGI greater than $200,000 will be subject to the tax on their net investment income. 15
Trusts and estates will be subject to the tax on their net undistributed unearned investment income if their MAGI amount exceeds the amount at which the highest income tax bracket is imposed on a trust or an estate. 16 In 2014, a trust or estate will be in the maximum tax bracket of 39.6% when its income exceeds $12,150. 17
A taxpayer's net investment income includes interest, dividends, annuities, royalties, and rent. 18 It also includes other income from a trade or business that is a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities 19 and the gain resulting from the disposition of property held in these types of trades or businesses. 20 Other income arising from a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities is not included in net investment income, nor is the gain from the disposition of property held in such a trade or business. 21
Recently issued regulations provide a safe-harbor exception to this new net investment income tax for certain real estate professionals. For a real estate professional who participates in a rental real estate activity for more than 500 hours during the tax year or who participated in such real estate activities for more than 500 hours in five or more years during the 10 immediately preceding tax years, the gross rental income and gain or loss resulting from the disposition of property used in the rental real estate activity will be treated as arising from an active trade or business. 22 As a result, this income will not be included in the taxpayer's net investment income. 23
This article starts with a discussion of the passive activity rules as applied to non-real estate activities, including a review of the material participation tests, which also apply to rental real estate activities. The article next discusses the application of passive activity rules to real estate activities, including a review of statutory and regulatory criteria to qualify as a real estate professional, making an election to classify all rental activity as a single activity, and the relaxation of the passive activity rules for rental activity for a taxpayer who actively participates in the activity. The next section discusses issues and recent tax cases involving a taxpayer's burden of proving that the taxpayer is a real estate professional and that the taxpayer materially participates in rental real estate activities. In the majority of those recent cases, the taxpayers' claimed losses arising from activities were disallowed because they failed to provide sufficient, credible substantiation of their participation in the activities. Finally, the article discusses the imposition of accuracy-related penalties in those court cases.The Passive Activity Rules and the Material Participation Test
To avoid the classification of an activity as passive, taxpayers engaged in the rental of real estate must overcome two hurdles. First, the taxpayers must establish that they qualify as real estate professionals to avoid the general rule that all rental activity is per se passive. 24 Second, if the taxpayer qualifies as a real estate professional, the taxpayer must establish that the taxpayer materially participated in the rental real estate activity. 25 If the taxpayer does not meet both of these requirements, any losses that arise from the rental activity will be considered passive and will be subject to the passive activity loss limitation. 26
In a number of recent cases, the rental real estate activities were deemed passive because the taxpayers were unable to substantiate that they were real estate professionals. 27Material Participation Test Under the Temporary Regulations
Temp. Regs. Sec. 1.469-5T(a) provides that a taxpayer can establish material participation in an activity by satisfying one of seven tests:
- The individual participates in the activity for more than 500 hours during such year;
- The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
- The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
- The activity is a significant participation activity (within the meaning of [Temp. Regs. Sec. 1.469-5T(c)]) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
- The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
- The activity is a personal service activity (within the meaning of [Temp. Regs. Sec. 1.469-5T(d)]), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
- Based on all of the facts and circumstances (taking into account the rules in [Temp. Regs. Sec. 1.469-5T(b)]), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
A taxpayer bears the burden of establishing material participation by reasonable means. To prove that a taxpayer may not have materially participated, IRS agents are directed in passive activity cases to "[l]ook for time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc." 28
To meet the seventh test under Temp. Regs. Sec. 1.469-5T(b)(2)(iii), the facts-and-circumstance test, the taxpayer must participate in the activity for at least 100 hours. And, under Temp. Regs. Sec. 1.469-5T(b)(2)(ii), the taxpayer's services performed in management activities are not taken into account in determining whether he or she materially participates unless (1) no person other than the taxpayer receives compensation for those services and (2) no person performs management services for more hours than the taxpayer.Application of Passive Activity Rules to Real Estate Activities
The passive activity loss rules generally apply to all rental activities regardless of whether a taxpayer materially participates in the business: 29 "A rental activity generally is treated as a per se passive activity." 30 Under Regs. Sec. 1.469-9(b)(3), "Rental real estate is any real property used by customers or held for use by customers in a rental activity within the meaning of §1.469-1T(e)(3)." Temp. Regs. Sec. 1.469-1T(e)(3)(i) provides that an activity is a rental activity if "[d]uring such taxable year, tangible property held in connection with the activity is used by customers or held for use by customers." However, if the average customer use of tangible property is seven days or less, the rental will not be considered rental activity under the passive activity rules. 31
In an important exception to this rule, Congress in 1993 amended the passive activity loss statute to provide an exception for real estate professionals. Under Sec. 469(c)(7)(B), taxpayers who (1) materially participate in real property trades or business for more than 750 hours and (2) perform more than 50% of their personal services they perform during the year in real property trades or businesses will not be subject to the general rule that all rental activities are treated as passive.
The House committee report provided the following explanation for this exception for real estate professionals:
The committee considers it unfair that a person who performs personal services in a real estate trade or business in which he materially participates may not offset losses from rental real estate activities against income from nonrental real estate activities or against other types of income such as portfolio investment income. 32
Clearly, the real estate professional test applies to individuals. It also applies to closely held C corporations. The Code provides that these rules may be satisfied by a closely held C corporation if more than 50% of the gross receipts of the corporation are derived from real property trades or businesses in which it materially participates. 33
Can a trust qualify as a real estate professional? In Frank Aragona Trust, 34 the IRS contended that a trust did not qualify because it could not perform personal services to meet the material participation requirement for the Sec. 469(c)(7)(B) exception. But the Tax Court held that the three trustees, who were also employees of a real estate holding company that the trust wholly owned, provided personal services on the trust's behalf that should be considered in the material participation determination. 35 Including the trustee/employees' personal services, the Tax Court found that the trust qualified as a real estate professional and was not subject to the passive activity loss limitations. It should be noted the Tax Court did not decide whether the services performed by nontrustee employees of the wholly owned real estate holding company should be taken into account in determining whether the trust should be classified as a real estate professional. 36
The definition of material participation for determining whether a taxpayer is a real estate professional is the same as determining whether a taxpayer materially participates in an activity. 37
In determining whether a taxpayer meets the 750-hour requirement, all of a taxpayer's real estate activities are taken into account. 38 Real estate activities include more than real estate rental activities. Sec. 469(c)(7)(C) provides, "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."
According to Regs. Sec. 1.469-9(e)(3)(ii), a taxpayer's real estate activity management services may be taken into account only if those services are performed in managing the taxpayer's real estate interests. In Fitch, 39 a husband and wife each claimed rental real estate losses on their joint income tax returns arising from their separate real estate activities. The wife, who was a licensed real estate agent and worked as an independent contractor for RE/MAX, met the requirements to be classified as a real estate professional.
The court then was confronted with the issue of whether the husband, who was an accountant, materially participated in his real estate activities. The Tax Court found that the husband and wife each separately performed all the day-to-day management of each of their separate real estate properties, including bookkeeping, making repairs, executing contracts, screening tenants, advertising, paying taxes and utilities, procuring insurance, and dealing with homeowners' associations. They occasionally hired a contractor, such as an electrician or an engineer, to assist them. The court found that both the husband and wife satisfied the material participation test because their participation in their respective rental real estate activities was substantially all of the participation in those activities. 40
In a number of court cases, individuals who worked full time in a non-real estate activity were unable to meet the requirements to be a real estate professional. Proving that at least 50% of the taxpayer's personal services during the tax year are performed in rental real property trades or businesses may be very difficult to establish for an individual who is employed for significant hours in a non-real estate business. 41
A married couple filing a joint return will qualify as real estate professionals only if one spouse separately satisfies the two statutory tests. 42 However, to determine whether a taxpayer materially participates in the rental real estate activity, Sec. 469(c)(7)(B) permits the taxpayer's spouse's participation to be taken into account. A married taxpayer filing separately must establish that he or she separately meets both statutory tests to qualify as a real estate professional and will not satisfy this requirement through spousal attribution. 43
Taxpayers who qualify as "real estate professionals" are not subject to the per se rule that all rental activity is passive. 44 However, in addition to proving that the taxpayers are real estate professionals, the taxpayers must also prove that they materially participate in the rental real estate activity. 45 In Perez, 46 the Tax Court rejected a taxpayer's argument that since she qualified as a real estate professional, all of her real estate activities were deemed to be nonpassive activities. The Tax Court explained that a taxpayer may not group a rental real estate activity with any other activity of the taxpayer under Regs. Sec. 1.469-9(e)(3)(i). Thus, the taxpayer could not group her professional real estate activities as a real estate loan agent and broker with her activities as a rental real estate owner. The losses arising from her rental activity were disallowed because she failed to substantiate that she materially participated in the rental real estate activity.
Electing to Treat Multiple Rental Real Estate Activities as One Activity
Taxpayers who engage in multiple rental real estate activities will treat each activity as a separate activity unless the taxpayers elect under Sec. 469(c)(7) to treat all those rental real estate activities as one activity. Taxpayers who engage in multiple rental real estate activities may find it difficult to qualify as real estate professionals if they do not make the election.
Example 1: S owns three buildings: A, B, and C. Assume that S materially participates in C but does not materially participate in A and B. Before 2014, S did not elect to treat the three buildings as one activity. Therefore, S would need to satisfy the material participation requirements separately for each activity.
As of the close of 2013, A and B, respectively, have disallowed passive losses of $30,000 and $10,000. At the close of 2014, A and B each had losses of $5,000, and C had $25,000 of income. S elects to treat buildings A, B, and C as one activity in her timely filed original 2014 tax return.
As one activity, the net loss arising from B and A, $10,000, will offset $10,000 of the $25,000 income generated by C. The remainder of C's income, $15,000, can be offset by the unused, carried-over passive activity loss of B and A, $40,000. As such, S will report no income from the real estate activity in 2013 and will have $25,000 of unused passive losses that may be carried over to 2015. 47
Caution: Under Regs. Sec. 1.469-9(e)(3)(i), the taxpayer may not group his or her rental real estate activities with non-rental real estate activities in determining his or her material participation in rental real estate activities.
Example 2: R considers himself a complete real estate developer and manager. He acquires land, constructs buildings, and rents and manages the buildings. Although R's real estate acquisition and construction activities are taken into consideration in determining whether he is a real estate professional, for the purpose of determining whether a taxpayer materially participates in rental real estate activities, the construction and acquisition activities are not taken into account. Thus, under Regs. Sec. 1.469-9(e)(3)(i), only R's rental real estate activities are taken into account when determining whether he materially participated.
In computing whether the taxpayer materially participated, the Tax Court has held that a taxpayer cannot elect to combine his activities as a real estate salesman with his rental real estate activities. 48
A taxpayer can elect to treat all rental real estate activities as one activity by filing a statement with the taxpayer's original income tax return declaring that (1) the taxpayer is eligible to file an election and (2) the election is being made under Sec. 469(c)(7)(A). A taxpayer can file this election only if the taxpayer qualifies as a real estate professional. 49
Rev. Proc. 2011-34 permits taxpayers to make late elections by attaching a statement to an amended return for the most recent tax year that identifies the year that the late election is to be effective and explains why the election was not timely filed. 50 Under Regs. Sec. 1.469-9(g)(3), a taxpayer may revoke the election to group rental real estate activities as one activity only if there is a material change in facts and circumstances.
Sec. 469(i)(1) permits certain eligible taxpayers who actively participate in rental real estate activity to deduct up to $25,000 of losses arising from the rental real estate activity, if the taxpayer cannot meet the material participation test. But, under Sec. 469(i)(6)(A), an individual will not be considered to actively participate in any rental real estate activity if the taxpayer owns less than a 10% interest in the activity at any time during the year.
The active participation requirement is a much lower bar to meet than the material participation standard: 51 The taxpayer must participate only "in a significant and bona fide sense in making management decisions or arranging for others to provide services." 52 The Tax Court in Maguire 53 stated:
The active participation standard can be satisfied without regular, continuous, and substantial involvement in an activity; the standard is satisfied if the taxpayer participates in a significant and bona fide sense in making management decisions (such as approving new tenants, deciding on rental terms, approving capital expenditures) or arranging for others to provide services such as repairs.
An IRS training manual states:
As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager. 54
The $25,000 permitted loss is reduced by 50% of the taxpayer's adjusted gross income (AGI) in excess of $100,000. 55 Thus, a married couple who are married filing jointly and have an AGI that exceeds $150,000 will not be permitted a deduction arising from a real estate activity in which the husband or wife actively participates.
For a taxpayer who is married but files separately, under Sec. 469(i)(5), the maximum deduction is $12,500, and it phases out by 50% of a taxpayer's AGI in excess of $50,000. Thus, a married individual filing separately will not be permitted a deduction arising from a rental real estate activity in which he or she actively participates if his or her AGI exceeds $75,000.Burden of Proof and Substantiating Material Participation
A taxpayer bears the burden of proving that the IRS's determination and notice of deficiency are erroneous. 56 However, the burden of proof is shifted back to the IRS if the taxpayer complies with the relevant substantiation requirements, maintains all required records, and cooperates with the IRS about witnesses, information, documents, meetings, and interviews. 57 If a taxpayer fails to provide the information or cooperate, the burden of proof remains with him or her. 58
How does a taxpayer establish material participation in an entity? Temp. Regs. Sec. 1.469-5T(f)(4) provides:
The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of 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.
Notwithstanding the foregoing, "the regulations do not allow a postevent 'ballpark guesstimate.' " 59 Taxpayers who prepare contemporaneous logs of their real estate activities may be able to establish the hours spent participating in the activities. In Adeyemo, 60 the taxpayer introduced a logbook that provided an almost-daily account of his activities. The IRS argued that the logbook was not contemporaneous and was likely created shortly before trial. The IRS stated that the taxpayer provided inconsistent answers in response to IRS counsel's question concerning when the taxpayer began to maintain the logbook. In addition, the IRS auditor credibly testified that before the audit, the taxpayer stated that he had not kept any sort of logbook. Notwithstanding the foregoing, the "thoroughness and consistency of the logbook" convinced the court it was an accurate account, and the court found that Temp. Regs. Sec. 1.469-5T(f)(4) states "that the taxpayer's records need not be contemporaneous." Nonetheless, the number of hours that the taxpayer materially participated according to the logbooks was inadequate to meet the requirements to be a real estate professional.
Merino 61 involved the question whether the taxpayer-husband was a real estate professional. In 2007, the husband, who lived in California, owned seven properties in other states. He used a management company to lease the properties, collect rent, and look into problems as they arose. The taxpayer was also the sole shareholder of an S corporation that ran a mortgage lending processing business. The taxpayer's duties in the mortgage business involved supervising a small number of employees, making calls, and bringing borrowers and potential buyers to the business. In 2007, he received a $20,000 salary and earned approximately $112,500, as was set forth on Schedule K-1, Shareholder's Share of Income, Deductions, Credits, etc. The taxpayer-husband was also involved in a third business, the sale and distribution of an acai berry drink, which he reported on Schedule C, Profit or Loss From Business (Sole Proprietorship). The taxpayers filed their delinquent 2007 tax return in 2010 and deducted losses from all seven rental properties on Schedule E, Supplemental Income and Loss.
The IRS issued a notice of deficiency disallowing the losses from the taxpayer's real estate activities. The court upheld the finding that the taxpayer failed to establish that he performed more than half of his services in the rental real property trade or business or that he performed more than 750 hours in that business, pointing to the taxpayer's failure to establish how many hours he devoted to his other two businesses. And the court stated that, although the taxpayer credibly testified that he prepared the summary in 2007 or 2008 shortly after a flood destroyed his records, it was no more than a "ballpark guesstimate." 62 Although the taxpayer's estimates were well-meaning, the court stated that they were unreliable and uncorroborated. The taxpayer was unable to recall any specifics about any particular entry, and he introduced no corroborating evidence, such as invoices or letters to and from homeowners' associations.
In Hoskins, 63 a taxpayer elected to include all of his rental real estate activity as one activity but failed to prove that he materially participated in any of the real estate activities. Therefore, all the activities were classified as passive.
In Vandegrift, 64 the taxpayer was employed as a salesman at a salary of $120,000. Despite his outside employment, he maintained that he was a real estate professional who spent more than 50% of his time and more than 750 hours on real estate activities. Because he did not maintain contemporaneous records of his time and did not submit any other records to verify his estimate of his time spent as a salesman or as a real estate businessman, he did not establish that he was a real estate professional. 65Accuracy-Related Penalty
If a taxpayer improperly deducts losses arising from a passive activity, the IRS may, in addition to the assessment of unpaid taxes and interest, assess an accuracy-related penalty for negligence or disregard of rules or regulations, or alternatively, because the underpayment is due to a substantial understatement of income tax. 66 The penalty is equal to 20% of the understated tax liability.
Sec. 6662(c) provides that "the term 'negligence' includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term 'disregard' includes any careless, reckless, or intentional disregard." 67 Under Sec. 6662(d)(1)(A), a substantial understatement of tax exists if the understatement of income tax exceeds the greater of 10% of the tax required to be shown on the return, or $5,000.
Under Sec. 6664(c), an accuracy-related penalty will not apply if the taxpayer had reasonable cause for the underpayment and (2) acted in good faith with respect to the underpayment. Reasonable cause and good faith are determined on a case-by-case basis, taking into account all pertinent facts and circumstances. Once the IRS establishes that a penalty is appropriate, the taxpayer "must come forward with persuasive evidence that the penalty is inappropriate because he or she acted with reasonable cause and in good faith." 68 The regulations provide:
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. . . . Generally, the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge and education of the taxpayer. An isolated computational or transcriptional error generally is not inconsistent with reasonable cause and good faith. Reliance on an information return or on the advice of a professional tax advisor or an appraiser does not necessarily demonstrate reasonable cause and good faith. Similarly, reasonable cause and good faith is not necessarily indicated by reliance on facts that, unknown to the taxpayer, are incorrect. Reliance on an information return, professional advice or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. 69
The Tax Court has stated:
We have found that reliance on a tax professional demonstrates reasonable cause when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and consistent with ordinary business care and prudence, relies on the adviser's professional judgment as to the taxpayer's tax obligations. 70
In Almquist, the Tax Court found that relying on an accountant was not reasonable where the taxpayer failed to provide adequate supporting documentation of the hours worked. 71 In another case, the Tax Court rejected a taxpayer's argument that the penalty should be abated because of the complicated passive activity rules since the taxpayer did not show that he consulted with competent tax professionals. 72Conclusion
Taxpayers who engage in rental real estate activities would be prudent to prepare and save contemporaneous documents to substantiate the time spent on and the services performed for the activities. This is especially important for taxpayers who are employed in non-real property trades or businesses and must establish that they are real estate professionals who devote more than 50% of their personal services during the year to real property trades or businesses.
Another important point for taxpayers who want to qualify as real estate professionals is to make sure they elect to group their rental real estate activities together so they do not have to satisfy the hour requirements separately for each property.
Ideally, taxpayers should prepare contemporaneous time logs that detail the services rendered, where the services were performed, and the time expended in performing the services. Additionally, other records that substantiate the taxpayer's time log should be preserved. A taxpayer's credit card expenditures, invoices, toll receipts, and phone records may help substantiate his or her activities.
Advisers should ensure that clients understand that they have the burden of substantiating their participation in real property trades and businesses and their material participation in rental real estate activities. In addition, advisers should stress to clients that keeping records that substantiate material participation as it occurs will be more accurate, reliable, and less cumbersome than preparing the records several years later during a tax audit.
1 Sec. 469(c)(2).
2 Adeyemo , T.C. Memo. 2014-1.
3 Sec. 469(c)(7)(B). A closely held C corporation is considered a real estate professional as long as 50% of its gross receipts for the tax year are derived from real property trades and businesses in which the corporation materially participates (Sec. 469(c)(7)(D)(i)). For the purpose of the 50% test, portfolio income is not included in gross receipts (Regs. Sec. 1.469-9(c)(2)).
4 For example, the recently issued net investment income tax regulations refer to "a real estate professional (as defined in section 469(c)(7)(B))" (Regs. Sec. 1.1411-4(g)(7)(i)). See also the Instructions to Form 8582, Passive Activity Loss Limitations , p. 2, and The Passive Activity Loss Audit Technique Guide published by the IRS in 2005 for training purposes, Training 3149-115, Catalog Number, ch. 2, pp. 2-4 to 2-6.
5 See Almquist , T.C. Memo. 2014-40; Adeyemo , T.C. Memo. 2014-1.
6 Sec. 469(a) provides that the passive activity rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations. A corporation is closely held if more than 50% of the corporation's equity is owned, during the last half of the tax year, by five or fewer shareholders. See Sec. 469(j)(2), which cross-references to Sec. 465(a)(1)(B), which cross-references to Sec. 542(a)(2). Although partnerships and S corporations are not listed, the passive activity loss rules apply to partners and S corporation shareholders. Although the passthrough entity is ignored, the equity owners are treated as though they owned direct interests in the activities. Income generated by a passthrough entity from the rental of property that is used in a trade or business in which the equity owner materially participates is not deemed passive income. As such, the equity owner will be unable to use the passive losses of other passive activities to offset the income. Regs. Sec. 1.469-2(f)(6).
7 Sec. 469(d)(1); Temp. Regs. Sec. 1.469-2T.
8 Sec. 469(d)(2).
9 Sec. 469(b).
10 Sec. 469(f).
11 Sec. 469(g)(1).
12 Sec. 1402(a). Issues may arise concerning whether payments were rentals from real estate or were derived from other sources. See Morehouse , 140 T.C. No. 16 (2013), where the Tax Court held that payments from the U.S. Department of Agriculture's Conservation Reserve Program were not from rental real estate and therefore were included in the taxpayer's self-employment income.
13 Patient Protection and Affordable Care Act, P.L. 111-148, §1402, which added Sec. 1411, Imposition of Tax , included in new chapter 2A, Unearned Income Medicare Contribution .
14 The modifications to a taxpayer's adjusted gross income involve income exclusions for citizens or U.S. residents who are living abroad under Sec. 911 (Sec. 1411(d)).
15 Secs. 1411(a) and (b).
16 Sec. 1411(a)(2); Regs. Sec. 1.1411-3(a)(1)(ii).
17 Rev. Proc. 2013-35, §3.01, Table 5; Sec. 1(e).
18 Sec. 1411(c)(1).
19 Secs. 1411(c)(1) and (2); Regs. Sec. 1.1411-5.
20 Regs. Sec. 1.1411-4(b)(2).
21 Secs. 1411(c)(1) and (2); Regs. Sec. 1.1411-1(d)(4)(iii).
22 Regs. Sec. 1.1411-4(g)(7). The regulations provide that a real estate professional is as "defined in section 469(c)(7)(B)." Regs. Sec. 1.1411-4(g)(7)(i). The regulations also provide that participation will have the same meaning as that which counts for determining material participation. Regs. Sec. 1.1411-4(g)(7)(ii)(A).
23 Regs. Sec. 1.1411-4(g)(7).
24 Secs. 469(c)(2) and (7). See Adeyemo , T.C. Memo. 2014-1.
25 Sec. 469(c)(7)(B).
26 Regs. Sec. 1.469-9(e)(1).
27 See Almquist , T.C. Memo. 2014-40; Oderio , T.C. Memo. 2014-39; Adeyemo , T.C. Memo. 2014-1; Hassanipour , T.C. Memo. 2013-88; and Merino , T.C. Memo. 2013-167.
28 Passive Activity Loss Audit Technique Guide , published by the IRS in 2005 for training purposes, Training 3149-115, Catalog Number 83479V, p. 2-6.
29 Secs. 469(c)(2) and (4).
30 Specks , T.C. Memo. 2012-343.
31 Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A). See Hoskins , T.C. Memo. 2013-36, where the Tax Court held that several of the taxpayer's real estate properties were not considered rental properties since the average customer rentals were for a period of less than seven days.
32 H.R. Rep't No. 103-111, 103d Cong., 1st Sess. at 612-613 (May 25, 1993).
33 Secs. 469(c)(7) and (c)(7)(D)(i); Regs. Sec. 1.469-9(c)(2).
34 Frank Aragona Trust , 142 T.C. No. 9 (2014).
35 Citing 1 Restatement, Trusts 3d §2 (2003) ("a trust 'is a fiduciary relationship with respect to property, . . . subjecting the person who holds title to the property to duties to deal with it for the benefit of' others").
36 The Tax Court stated that it was unnecessary for it to determine whether Sec. 469(c)(7)(D)(ii), which provides that "for purposes of sec. 469(c)(7)(B) personal services performed as an employee are generally not treated as performed in real-property trades or businesses," applied. The IRS limited its challenges to (1) whether the trust was categorically barred from being a real estate professional, and (2) if it was a real estate professional, whether it materially participated in real estate activities. See fn. 16 in Frank Aragona Trust , 142 T.C. No. 9 (2014).
37 Regs. Sec. 1.469-9(b)(5); see "Material Participation Test Under the Temporary Regulations" on the previous page for a discussion of the alternative tests set forth in Temp. Regs. Sec. 1.469-5T(a).
38 Fitch , T.C. Memo. 2012-358; Fowler , T.C. Memo. 2002-223.
39 Fitch , T.C. Memo. 2012-358.
40 See Temp. Regs. Sec. 1.469-5T(a)(2).
41 See Almquist , T.C. Memo. 2014-40; Oderio , T.C. Memo. 2014-39; Adeyemo , T.C. Memo. 2014-1; Bartlett , T.C. Memo. 2013-182; Hassanipour , T.C. Memo. 2013-88; Merino , T.C. Memo. 2013-167; Vandegrift , T.C. Memo. 2012-14; Harnett , T.C. Memo. 2011-191, aff'd, 496 Fed. Appx. 963 (11th Cir. 2012); Specks , T.C. Memo. 2012-343.
42 Sec. 469(c)(7)(B); Regs. Sec. 1.469-9(c)(4). See Adeyemo , T.C. Memo. 2014-1; Fitch , T.C. Memo. 2012-358.
43 Oderio , T.C. Memo. 2014-39.
44 See 2013 Instructions to Form 8582, Passive Activity Loss Limitations , p. 2.
45 Regs. Secs. 1.469-9(b)(6), 1.469-9(c)(3), and 1.469-9(e)(1).
46 Perez , T.C. Memo. 2010-232. See also Hoskins , T.C. Memo. 2013-36.
47 Regs. Sec. 1.469-9(e)(4), Example.
48 Hoskins , T.C. Memo. 2013-36. See also Perez , T.C. Memo. 2010-232.
49 Regs. Sec. 1.469-9(g)(3). See Sec. 469(c)(7), which provides that a taxpayer must (1) materially participate in real property trades or business for more than 750 hours, and (2) more than 50% of personal services the taxpayer performed during the year must be in real property trades or businesses in which he materially participates.
50 The procedure is in lieu of applying for a private letter ruling to obtain relief from late filing, which requires a taxpayer to pay a large user fee.
51 Azimzadeh , T.C. Memo. 2013-169.
52 Ani , T.C. Summ. 2011-119.
53 Maguire , T.C. Memo. 2012-160.
54 The Passive Activity Loss Audit Technique Guide , Training 3149-115 (02-2005), Catalog Number 834979V.
55 Sec. 469(i)(3).
56 Tax Court Rule 142(a)(1); Welch v. Helvering , 290 U.S. 111 (1933); Merino , T.C. Memo. 2013-167.
57 Secs. 7491(a)(1) and (2); Merino , T.C. Memo. 2013-167.
58 Adeyemo , T.C. Memo. 2014-1; Merino , T.C. Memo. 2013-167.
59 Moss , 135 T.C. 365, 369 (2010) (citing Bailey , T.C. Memo. 2001-296, and Goshorn , T.C. Memo. 1993-578).
60 Adeyemo , T.C. Memo. 2014-1.
61 Merino , T.C. Memo. 2013-167.
62 The court contrasted this case with that of Pohoski , T.C. Memo. 1998-17, where it accepted the taxpayer's post-event narrative because it was compiled using contemporaneous records and was supported with credible testimony and other objective evidence.
63 Hoskins , T.C. Memo. 2013-36.
64 Vandegrift , T.C. Memo. 2012-14.
65 See also Harnett , T.C. Memo. 2011-191, aff'd, 496 Fed. Appx. 963 (11th Cir. 2012), where the Tax Court held that the chairman and CEO of a bank failed to establish with credible evidence that he met the 750-hour requirement. Although the taxpayer testified he spent only 10 hours a month working at the bank, the court stated that considering he was both chairman of the board and CEO, and the highest-paid employee, the testimony strained credibility.
66 Secs. 6662(a) and (b).
67 Sec. 6662(c).
68 Hassanipour , T.C. Memo. 2013-88, citing Sec. 6662(c); and Higbee , 116 T.C. 438, 448-449 (2001).
69 Regs. Sec. 1.6664-4(b)(1).
70 Specks , T.C. Memo. 2012-343, citing Sec. 6664(c)(1); Neonatology Assocs. P.A. , 115 T.C. 43 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002). In Specks , the court upheld the accuracy penalty where the taxpayer did not establish the return preparer was a competent professional with significant expertise to justify reliance, or that the taxpayer provided the return preparer with all relevant information.
71 Almquist , T.C. Memo. 2014-40.
72 Hassanipour , T.C. Memo. 2013-88.
|John Skarbnik is a professor of taxation at Fairleigh Dickinson University in Madison, N.J., and is tax counsel to the Roseland, N.J., law firm of Walder Hayden PA. He is admitted to the state bars of New Jersey and New York and is also a New Jersey CPA. For more information about this article, contact Prof. Skarbnik at firstname.lastname@example.org.|