Taxpayers' Carriage House Losses Are Nondeductible Under Passive Loss Rules

(Parker Tax Publishing July 2024)

The Tax Court held that losses incurred by a married couple in connection with a carriage house they built as a rental property were nondeductible passive losses because neither spouse qualified as a real estate professional under Code Sec. 469(c)(7)(B). The court did not find credible the husband's testimony that he spent 2,500 hours in the year at issue constructing the carriage house in addition to working full-time as an employee; therefore, the court concluded that the taxpayer did not spend more than one-half of his total personal services on the rental real estate activity in the year at issue. Foradis and Moore v. Comm'r, T.C. Summary 2024-13.

Background

Timothy Foradis and Jessica Moore filed a 2020 joint federal income tax return, prepared by a tax return preparer, that consisted of (1) Form 1040, U.S. Individual Income Tax Return, (2) Form 4562, Depreciation and Amortization (Including Information on Listed Property), (3) Form 8995, Qualified Business Income Deduction Simplified Computation, (4) Schedule 1, Additional Income and Adjustments to Income, (5) Schedule 3, Additional Credits and Payments, and (6) Schedule E, Supplemental Income and Loss. On the Schedule E, Foradis and Moore reported rents received of $875, claimed deductions for mortgage interest of $6,729, and claimed a depreciation expense deduction of $16,522. As a result they claimed a rental real estate loss deduction of $22,376.

In 2020 Moore earned wage income of $82,873 and worked approximately 40 hours a week during the entire year as a full-time employee. In 2020 Foradis earned wage income of $78,501 and worked approximately 40 hours a week during the entire year as a full-time employee.

Foradis and Moore decided to build a new building that they would rent out. During 2018 they received a building permit from their city of residence allowing them to build what they refer to as "the carriage house." During 2020, while he was working full time, Foradis found time to construct the carriage house. He hired persons to do the work he was not capable of doing. Moore did not work on constructing or renting the carriage house. After Foradis and Moore built the carriage house, Foradis hired a rental management company on October 1, 2020, to manage the carriage house rental, including cleaning, vetting prospective tenants, and providing security. Foradis and Moore rented out the carriage house as a short-term rental property beginning in October 2020.

In October 2022, the IRS began an examination of Foradis's and Moore's 2020 joint return. In 2023, the IRS issued a notice of deficiency disallowing the $22,376 rental real estate loss deduction and determining a deficiency. Foradis and Moore took their case to the Tax Court.

Code Secs. 162 and 212 generally allow a taxpayer to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business or for the production of income. In the case of an individual, Code Sec. 469(a)(1) and (b) generally disallow any current deduction for a passive activity loss. The effect of the passive activity loss disallowance rule is that a deduction related to a passive activity is allowed against income from the passive activity, and the excess (i.e., the amount by which the deduction related to the passive activity exceeds the income from the passive activity) cannot be deducted from income from activities other than the passive activity.

Generally, under Code Sec. 469(a)(1) and (c)(1), a passive activity is any trade or business in which the taxpayer does not materially participate. Code Sec. 469(c)(2) provides that rental activity is passive unless the taxpayer qualifies as a real estate professional as defined in 469(c)(7)(B). If a taxpayer meets the definition of a real estate professional, then Code Sec. 469(c)(2) does not apply, and the taxpayer's rental real estate activity, if conducted as a trade or business or for the production of income, is not treated as a passive activity if the taxpayer materially participates in the activity.

Code Sec. 469(c)(7)(B) provides two conjunctive tests that a taxpayer must satisfy to qualify as a real estate professional. A taxpayer qualifies as a real estate professional if:

(1) more than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates, and

(2) such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

In the case of a joint federal income tax return the above requirements are satisfied if either spouse separately satisfies these requirements. Foradis and Moore, however, asserted that only Foradis was a real estate professional. Foradis claimed that he spent approximately 2,500 hours constructing the carriage house in 2020. He asserted that he worked on the carriage house after work and on the weekends, as well as during two weeks of vacation from his full-time job.

Analysis

The Tax Court held that Foradis and Moore could not deduct their rental real estate losses in 2020 under the passive loss rules in Code Sec. 469. The court believed that Foradis spent a lot of time constructing the carriage house, but it did not find it credible that he spent more hours constructing the carriage house than he did at his full-time job. The court found it implausible that Foradis, as he asserted, would work 40 hours each week at a full-time job and at the same time work about an additional 48 hours each week constructing the carriage house.

Assuming, without finding, that Foradis also performed personal services with respect to his and Moore's rental real estate activity, the court found that the couple could not prove that Foradis spent more than one-half of his total personal services performed in trades and businesses on his rental real estate activity during 2020. Thus, because Foradis failed the first of the Code Sec. 469(c)(7)(B) tests, Foradis and Moore were not entitled to deduct the loss from their rental real estate activity in 2020. Therefore, the court did not need to address the reasonableness of Foradis's and Moore's receipts or logs and whether Foradis performed more than 750 hours of services during the tax year in real property trades or businesses in which he materially participated.

For a discussion of rental losses, see Parker Tax ¶247,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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