Tax Day approaches.  I do know many people are placing within the hours on getting ready tax returns this week … or else placing within the minutes submitting Kind 4868.  However everyone knows—particularly when sad purchasers come to us to repair a return tousled by some whack-a-doodle preparer—simply placing in hours in submitting tax returns doesn’t make one a tax skilled.

In Robert L. Drocella and Pamela M. Drocella v. Commissioner, T.C. Summ. Op. 2023-12 (Apr. 3, 2023), Decide Leyden teaches us, and our purchasers, that merely placing within the hours engaged on one’s leases doesn’t make one an actual property skilled for §469 functions.  There the hard-working taxpayers weren’t allowed to flee §469’s prohibition on taking passive exercise losses in opposition to energetic earnings despite the fact that they collectively put in over 1,500 hours in working their six rental properties.  We study right now there are two different exams to being an actual property skilled and these taxpayers failed one among them:  they have been unable to indicate the Court docket the how the hours they labored their leases associated to the hours they spent incomes wages.  Particulars beneath the fold.

Legislation: Part 469 and Actual Property Professionals
Congress added §469 to the Code within the Tax Reform Act of 1986, Pub. L. 99–514, 100 Stat. 2085, 2233.  The thought in §469 is that there are two methods taxpayers earn earnings: they both actively work for his or her earnings or else they passively sit again and let others work it for them.  Congress had grow to be suspicious that the latter scenario, discovering that taxpayers would put money into actions that had no financial substance past producing tax advantages (typically paper losses).  Taxpayers would then use these losses to offset their actively earned earnings, usually from excessive salaried positions.  See Joint Committee Workers, “Basic Rationalization of Tax Reform Act of 1986” (“JCT Bluebook”) (Might 4, 1986) at 209-215.

To repair the issue §469 first differentiates earnings (and losses) incurred by every kind of exercise:  earnings and losses earned from energetic work go into one bucket; earnings and losses obtained from passive actions go into one other bucket.  The statute then creates a like-to-like rule: passive exercise losses (PALs) could solely offset passive exercise earnings.  They might not be used to offset earnings from actions the place the taxpayer truly work for his or her earnings.  Unused PALs could also be carried ahead into the subsequent yr. §469(b).  There are additionally plenty of different enjoyable guidelines that aren’t related to right now’s lesson.

So what’s the distinction between an energetic income-producing exercise and a passive one?  Nicely, §469(c) tells us, by defining what constitutes a passive exercise.  The overall definition in (c)(1) says that passive actions are these through which the taxpayer doesn’t materially take part.  The thought right here is {that a} “taxpayer who materially participated in an exercise [is] extra possible than a passive investor to method the exercise with a big nontax financial revenue motive, and to kind a sound judgment as as to whether the exercise had real financial significance and worth.”  JCT Bluebook at p. 212.

Following its basic definition of passive exercise  §469(c) lists particular varieties of passive actions.  For right now’s lesson, we give attention to §469(c)(2) which tells us that “any rental exercise” is passive per se.  Part 469(c)(4) then says that rental actions are passive no matter whether or not the taxpayer materially participates.  Apparently “any” does imply “any.”  Besides, after all, it doesn’t.  There are two conditions the place a rental exercise would possibly truly not be a passive exercise.

First, the rules make clear that “any” doesn’t embody short-term leases.  Thus, if the typical rental interval is 7 days or much less these should not robotically passive below §469(c)(2) however are as an alternative ruled by the fabric participation customary.  See Treas. Reg. 1.469-1T(e)(3).  For extra particulars, see Lesson From The Tax Court docket: Why Trip House Losses Are Tough To Deduct, TaxProf Weblog (Oct. 7, 2020).

Second, as related for right now, §469(c)(7) gives that rental actions of sure varieties of taxpayers should not passive actions.  What sort of taxpayers?  Nicely, most individuals (together with Decide Leyden) name them actual property professionals.  I’ll name them that as effectively.  Part 469, nevertheless, doesn’t use this time period.  As an alternative, it focuses on the taxpayer’s relationship to one thing referred to as a “actual property commerce or enterprise.”  That time period is outlined as “any actual property improvement, redevelopment, building, reconstruction, acquisition, conversion, rental, operation, administration, leasing, or brokerage commerce or enterprise.”  §469(c)(7)(C).  As I train it, the statutes creates three exams to find out whether or not a taxpayer’s relationship to that exercise qualifies for this exception to the per se rental rule:

(1) Proportionality check: the hours that the taxpayer places into that actual property commerce or enterprise should be greater than half of all of the hours that the taxpayer places into their energetic actions.  §469(c)(7)(B)(i);
(2) Hours Labored check: the taxpayer performs greater than 750 hours of companies throughout the taxable yr in that actual property commerce or enterprise.  §469(c)(7)(B)(ii); and
(3) Materials Participation check: the taxpayer materially participates in a “actual property commerce or enterprise.” §469(c)(7)(C).

Married {couples} submitting joint returns are allowed to mix their efforts to find out in the event that they meet the Materials Participation check, §469((h)(5), however not the opposite two exams.  That’s, Treas. Reg. 1.469-9(c)(4) says that one partner should individually fulfill each the Proportionality check and the Hours Labored check.

As you would possibly count on, all of this requires the taxpayers to show up their hours.  However they should be ready to indicate extra than simply what number of hours they put in to the rental.  With a purpose to present they meet the Proportionality check, they have to additionally present what number of complete hours they put into their different work.  Treas. Reg. 1.469-5T(f) offers the principles however the fundamental concept is that taxpayers should substantiate with satisfactory information, and contemporaneous information are the most effective.

Details
The tax yr at situation is 2018.  That yr Mr. Drocella labored full-time for Northrup Grumman.  Ms. Drocella labored full-time for the U.S. Division of Protection.  They didn’t, nevertheless, stipulate with the IRS or present the Court docket what number of hours they labored at their full-time jobs.  Absent that, we’d fairly assume it was 2,080 hours for the yr since that may be a typical (however not the one) quantity used to calculate Full Time Equivalents (FTE).

Along with their full-time employment, the Drocellas owned and managed six rental actual property properties.  That consumed quite a lot of hours, which they did monitor.  They saved a handwritten work log the place their recorded their time.  The log mirrored over 1,500 complete hours labored in 2018.  The log additional mirrored that Mr. Drocella put in over 750 hours and the Ms. Drocella put in lower than 750 hours.  Op. at 2.  The opinion doesn’t say what number of hours every partner claimed to have labored, however for causes that may grow to be obvious, one should assume that Mr. Drocella’s documented hours didn’t exceed 1,040.

On their 2018 return, the Drocellas reported their rental actual property exercise on a single Schedule E and there confirmed a lack of just below $63,000.  The opinion is silent on the main points of the loss.  Their Kind 1040 confirmed an AGI of $160,000.

The IRS denied the true property loss deduction as a result of it determined the rental exercise was a passive exercise.  Subsequently the losses have been Passive Exercise Losses (PALs) and couldn’t offset the Drocellas’ energetic earnings from their full-time employment.  The Drocellas disagreed and petitioned the Tax Court docket.

Lesson: It Takes Extra Than Simply Placing within the Hours
The Drocellas argued that they have been actual property professionals as a result of they put within the required hours.  In rejecting that argument, Decide Leyden teaches us that qualifying as an actual property skilled for §469 functions means extra than simply placing within the hours.  It means assembly all three of the exams: the Proportionality check; the Hours Labored check; and the Materials Participation check; .  Flunk one and the remainder don’t matter.

Right here, Decide Leyden finds that the Drocellas failed the Proportionality check.  Thus, whatever the hours they labored on the leases, they might not qualify as actual property professionals and the rental losses have been PALs.  The Drocellas merely failed to ascertain that the hours every one put in to the leases amounted to greater than one-half of the hours every put into their full-time employment.  Keep in mind, to satisfy the Hours Labored check, married taxpayers can not mix their hours.  One or each should put in over 750 hours.  Right here, Decide Leyden notes that solely Mr. Drocella even met the Hours Labored check.  Op. at 2.  However their failure to show what number of hours they really labored for his or her employers meant that they might not present Mr. Drocella met the Proportionality check.

Important to Decide Leyden’s choice was her discovering that “neither petitioner has offered the variety of hours she or he carried out as an worker.”  Op. at 4.  Thus, “petitioners can not show that greater than one-half of both petitioner’s complete private companies carried out in trades and companies have been carried out on their rental actual property actions throughout that yr.” Op. at 5. 

For instance, if Mr. Drocella had been capable of present that he labored at Northrup Grumman for two,080 hours, then he may qualify as an actual property skilled if he may additionally present that he put greater than 1,040 hours into the rental exercise and materially participated in it.  Identical for Ms. Drocella.  So that’s the reason we should assume that his hours totaled lower than 1,040 on the handwritten log.

As soon as she decides that the Drocellas failed the Proportionality check, Decide Leyden declines to wade into the questions of whether or not their handwritten logs precisely tracked their hours or whether or not both or each of them materially participated of their rental exercise.  These points merely didn’t matter as a result of taxpayer should meet all three exams to be actual property professionals.

Backside line: Being an actual property skilled is rather more than simply concerning the hours labored.

Remark 1:  Alert readers would possibly question why §469(i) didn’t a minimum of let the Drocellas use $25,000 of their losses in opposition to energetic earnings.  In any case, §469(i) permits taxpayers who should not certified actual property professionals to nonetheless offset as much as $25,000 of losses from their rental actions so long as they’ve “actively participated” within the rental.  §469(i)(1).  That’s a fairly low bar and from the details right here it appears the Drocellas would meet that requirement.  Nonetheless, different alert readers will see that $25,000 deduction is completely misplaced when AGI exceeds $150,000.  Right here, the Drocellas had reported an AGI of over $160,000, which not solely was greater than the $150,000 but in addition mirrored their claimed $63,000 loss.  See the 2018 Kind 1040 (keep in mind that one?), which informed taxpayers to reported Schedule E earnings or loss on Schedule 1 after which calculate AGI based mostly on that.

Remark 2:  Readers, assist me out!  I don’t see how taxpayers who meet the Hours Labored check would ever have problem exhibiting materials participation of their actual property commerce or enterprise.  That’s as a result of whereas the statute is kind of imprecise on what constitutes materials participation (it should be “common,” “steady,” and “substantial”), the rules give some good vibrant strains.  Specifically, Treas. Reg. 1.469-5T(a)(1) says a taxpayer can be handled as materially collaborating in an exercise if the taxpayer “participates within the exercise for greater than 500 hours” throughout the tax yr.

Keep in mind a taxpayer has to carry out greater than 750 hours of companies to satisfy the Hours Labored check.  That would appear to imply they’d at all times meet the regulation’s materials participation requirement.  Nonetheless, I warning that I’m no professional on this space and so I welcome any feedback correcting my impression.  It’s not necessary for right now’s lesson, however I’m at all times blissful to be informed I’m incorrect.  It’s how one learns.

Bryan Camp is the George H. Mahon Professor of Legislation at Texas Tech College Faculty of Legislation. He invitations readers to return every Monday (or Tuesday if Monday is a federal vacation) for one more Lesson From The Tax Court docket.

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