In a summary opinion (Moon, T.C. Summ. 2016-23), the Tax Court ruled that a couple could deduct passive losses from their rental real estate activities because they met the real estate professional and material participation rules under Sec. 469. However, the court did not allow certain listed property depreciation deductions that did not meet the substantiation requirements of Sec. 274(d). In both matters, the taxpayer's contemporaneous logs (or lack thereof) were the deciding factors in the court's decision.
Joseph and Darsey Moon were residents of Vermont. From 2008 to 2011, Mr. Moon was a full-time airline pilot, and Mrs. Moon worked less than 200 hours each year as a part-time ski instructor. The couple owned three rental real estate properties in Vermont. Mrs. Moon was the primary caretaker of the properties and worked considerably more hours on them than she did as a ski instructor. In each year from 2008 to 2011, she worked 1,002, 1,227, 834, and 863 hours, respectively, in managing the rental properties. She oversaw all management duties, including repairs and renovations. In addition, she maintained contemporaneous logs detailing the work that was done and the hours spent on each property.
From 2008 to 2011, the couple claimed losses on Schedule E, Supplemental Income and Loss, from their rental properties, and their tax returns were subsequently examined by the IRS. The primary issue under examination was whether the losses on Schedule E were passive and thus limited by Sec. 469. A secondary issue was whether the couple were entitled to and had properly substantiated depreciation expenses taken on a GMC truck used in the rental business.
Rule of Law
Sec. 469(a) generally disallows any passive activity loss for the tax year. Sec. 469(c) defines passive activities as those (1) that involve the conduct of any trade or business and (2) in which the taxpayer does not materially participate. Material participation is defined as the taxpayer's involvement in the operations of the activity on a regular, continuous, and substantial basis (Sec. 469(h)(1)). The regulations under Sec. 469 go into more detail on material participation and provide seven tests, but this case did not examine material participation in depth.
Regardless of whether the taxpayer materially participates, rental activities are generally treated as per se passive (Sec. 469(c)(2)). However, under the real estate professional rules of Sec. 469(c)(7)(B), a real estate rental activity is not considered passive if (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the year 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 business in which the taxpayer materially participates. In the case of a joint return, the real estate professional requirements listed above are satisfied if, and only if, either spouse separately satisfies the requirements. Thus, if one spouse meets the real estate professional requirements and material participation requirements, the activity is not considered passive (and spouses may not combine their hours to do so).
Depreciation deductions are generally disallowed under Sec. 274(d) with respect to listed property unless the taxpayer adequately substantiates (1) the amount of the underlying expense, (2) the time and place of travel or use of the property, (3) the business purpose of the expense, and (4) the business relationship of the persons using the property.
During the examination, the IRS conceded that Mrs. Moon materially participated in all of her real property trades or businesses during the years at issue. Even though the material participation test was met, however, the rental activities were still per se passive, according to the IRS, because she did not satisfy the real estate professional requirements of Sec. 469(c)(7)(B). The IRS also asserted that the logs were not prepared contemporaneously and therefore were unreliable. Put simply, the IRS did not believe she had met the 750-hour requirement. It argued that she spent many of her claimed hours on business and tax issues, which the Service referred to as "investor hours." It argued these investor hours should be excluded from her total hours spent on rental activities.
In addition, the IRS disallowed the depreciation amounts on the GMC truck due to lack of substantiation. A taxpayer is required to maintain records sufficient to substantiate expenses underlying deductions on an income tax return. Since Mrs. Moon did not provide a contemporaneous log to show all miles used for the truck, the deductions were disallowed.
For the four years in question combined, the IRS determined an income tax deficiency of nearly $48,000, mostly from reclassifying the rental activities as passive.
Tax Court Opinion
Surprisingly, when the IRS presented arguments in its brief, it failed to argue that Mrs. Moon had not materially participated in her real property trades or businesses for the years at issue. It is unclear whether the IRS had conceded on this point or erred in not including it. Regardless, the Tax Court concluded that the IRS had abandoned the issue.
After reviewing Mrs. Moon's logs and hearing her testimony, the court concluded that the logs were prepared contemporaneously and accurately. More than one-half of her hours in trades or businesses were performed in real property trades or businesses and she had performed more than 750 hours in real property trades or businesses in which she materially participated, the court found. The requirements of Secs. 469(c)(7)(B)(i) and (ii) had been met. Therefore, the rental activities were not per se passive, and since she also materially participated in the activities, they were not passive.
The court agreed with the IRS that the couple were not entitled to deduct the unsubstantiated depreciation expense for the GMC truck. Mrs. Moon had failed to maintain or produce a mileage log for it. In testimony, Mr. Moon stated that Mrs. Moon did not like using the truck and that he would park it at the airport for one to two weeks at a time while he traveled. This was contrary to the 100% business use percentage claimed on the tax return. With this in mind, the court disallowed the depreciation deductions for the truck. Fortunately for the taxpayer, these amounts were minimal compared with those associated with the real estate professional issue.
Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or email@example.com.
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