In Hickam, T.C. Summ. 2017-66, the Tax Court held that a mortgage broker was not a real estate professional and was subject to the passive activity loss rules of Sec. 469.
During the years at issue, Kurt Hickam brokered real estate mortgages and other loans secured by real estate, both as an independent contractor and as an employee. Hickam was a licensed real estate agent, but he did not operate, develop, redevelop, construct, reconstruct, or rent real estate in brokering mortgages or originating loans. He did, however, manage and maintain three rental real estate properties, two single-family homes, and a small apartment building, owned by himself and family members. Services that Hickam provided for the properties included placing ads, processing applications, inspecting conditions, and overseeing repairs and remodels. He received $6,000 annually for these services but did not keep contemporaneous records of the hours spent.
On his 2011 and 2012 tax returns, Hickam claimed rental real estate loss deductions of $47,730 and $48,945 for the three properties. Upon audit, the IRS disallowed the loss deductions, determining that the passive activity loss rules applied to the losses because Hickam was not a real estate professional. He argued to the court that his mortgage brokerage services and his loan origination services should be included for purposes of satisfying the real estate professional test. Additionally, he prepared a noncontemporaneous calendar for each month reflecting time spent on property management, mortgage brokerage services, and loan origination services.
Sec. 469(a) disallows a passive activity loss. Sec. 469(d)(1) defines the term "passive activity loss" as the amount by which the aggregate losses from all passive activities exceed the aggregate income from all passive activities for the year. Under Sec. 469(c)(1)(A), the term "passive activity" means any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. With the exception of real estate professionals described in Sec. 469(c)(7), Secs. 469(c)(2) and (c)(4) together consider any rental activity a passive activity, even if the taxpayer materially participates in the activity.
Sec. 469(c)(7)(B) provides two tests, both of which must be met, for a taxpayer to be classified as a real estate professional. The first test is met if more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year is performed in real property trades or businesses in which the taxpayer materially participates. The second test is met if the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates. The requirements of Sec. 469(c)(7)(B) can be met only by a taxpayer who materially participates in a real property trade or business. Sec. 469(c)(7)(C) defines the term "real property trade or business" as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
The court held that Hickam's mortgage brokerage services and his loan origination services did not constitute real property trades or businesses under Sec. 469(c)(7)(C). While the brokered loans were secured by real property, Hickam's services did not involve operating the real properties. Further, the court held that, while his mortgage brokerage services were a brokerage trade or business, they were not a real property brokerage trade or business, as he did not broker real estate, only loans.
Regarding the time spent in rental property management, the court held that Hickam failed to prove how much time he spent on the activity during 2011 and 2012. The court noted that the records were prepared well after the years at issue with ballpark estimates of time, and the descriptions were vague and nondescriptive. Further, he did not present as evidence at trial the leases, bank statements, checkbooks, bills, and receipts used to reconstruct the amount of time spent.
Considering all of Hickam's activities, the court held that he did not satisfy the two Sec. 469(c)(7)(B) tests to be treated as a real estate professional for 2011 or 2012 and thus could not deduct the rental real estate losses under the real estate professional exception. While the court found that he substantially understated his income and failed to maintain adequate records to substantiate the rental real estate loss, he did act reasonably and in good faith and was thus not liable for a Sec. 6662(a) accuracy-related penalty for 2011 or 2012.
Although the case is only a summary opinion and the taxpayer was representing himself, the opinion lines up with the IRS's previous opinion on the matter found in Chief Counsel Advice (CCA) 201504010. The court, like the IRS in CCA 201504010, drew its conclusion from the canons of statutory interpretation after reflecting on the tangled legislative history of Sec. 469(c)(7)'s enactment in the early 1990s. Although Congress initially included "finance operations" in the list of qualifying real property trade or business activities in an earlier, unenacted 1989 version of what would become Sec. 469(c), "finance operations" (along with "appraisal") was removed from the 1993 enacted version. The IRS concluded in the CCA that Congress did not intend for financing activities to constitute a real property trade or business and that financing activities should not be included in the definition of real property brokerage.
Ever since the enactment of the real estate professional rules, the IRS and taxpayers have struggled with what constitutes a real property trade or business within the 11 enumerated items in Sec. 469(c)(7)(C). The IRS clearly has authority to promulgate regulatory guidance to define these 11 terms but has chosen to deal with the definitional issues in examinations and in the courts.
Michael Dell is a partner at Ernst & Young LLP in Washington.
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