A recent case decided by the United States Tax Court (Hofinga, TC Summ. Op. 2013-43) reaffirmed the notion that taxpayers claiming to be a “real estate professional” should keep good records to support this designation.
In general, each year, taxpayers are required to determine the net income or loss from all of their “passive activities”. If the group of passive activities produces a net loss, the loss cannot offset non-passive income and must be carried forward indefinitely.
A taxpayer's rental real estate activity is not a passive activity if the taxpayer materially participates in the activity, and the taxpayer qualifies as a real estate professional.
For purpose of the passive loss rules, a taxpayer is a real estate professional if he or she meets both of the following tests:
- More than half of the personal services performed in a trade or business by the taxpayer are performed in real property businesses in which the taxpayer materially participates; and
- The taxpayer performs more than 750 hours of services during the tax year in real property businesses in which the taxpayer materially participates.
For a husband and wife, the 50% and 750-hour tests are satisfied only if one spouse individually satisfies the tests (or if both individually satisfy the tests). However, for determining material participation in an activity, participation by one spouse can be counted as participation for the other spouse [IRC Sec. 469(h)(5)]. Therefore, a husband and wife are eligible to take advantage of the special rule for real estate professionals if, during the tax year, either spouse materially participates in the rental real estate activity, and one spouse performs more than 50% of his or her personal services and more than 750 hours in real estate trades or businesses in which he or she materially participates.
In the Hofinga case, an individual was denied deductions for rental real estate losses because he did not establish that he met the 750-hour test. The taxpayer failed to keep a contemporaneous log of his time spent on rental real estate activities over the course of the years at issue and, therefore, attempted to establish his hours of material participation by constructing after-the-fact logs containing reasonable estimates based on calendars, bank statements, credit card records, property trip files, bills, receipts, and other records, as permitted by Temp. Reg. §1.469-5T(f)(4).
However, because the taxpayer employed property managers for some of his rental properties, and because the reconstructed logs contained significant sections of very generalized entries, it was impossible to establish that the taxpayer had satisfied the 750-hour test for either of the years in issue. Therefore the rental real estate activity was considered to be passive activity in those years, and the rental real property losses could not be deducted.
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