Couple Loses Deduction After Failing to Show Hours Spent on Rental Property by Others

(Parker Tax Publishing October 2020)

The Tax Court held that a couple could not deduct losses incurred from their rental activity because they could not prove they met the material participation requirements with respect to that rental activity. The court rejected the husband's argument that he spent 100 hours on the activity and thus met the requirement of Reg. Sec. 1.469-5T(a)(3) after finding that the couple did not have any documents showing the number of hours other individuals, such as the property management company that oversaw the rental of the property, spent on those activities in connection with the couple's rental property. Lucero v. Comm'r, T.C. Memo. 2020-136.

Background

Ronald Lucero owned a short-term-rental property (Sea Ranch property) in The Sea Ranch, California, that is several hours from his and his wife's home in Sacramento, California. He rented the property to tenants for 146 nonconsecutive days in 2014 and 152 nonconsecutive days in 2015. Ronald and his wife paid a property management company, Sea Ranch Escapes, LLC (Sea Ranch Escapes), to manage the property's day-to-day rental operations, which included advertising to prospective tenants, collecting deposit fees and rent, maintaining and cleaning the property between stays, landscaping, assisting the Luceros in hiring repair subcontractors, and responding to tenants' comments and complaints. Mr. Lucero retained control over certain administrative decisions, such as setting rental rates and approving expenses over $100 (unless there was an emergency).

To save money, the Luceros performed some upkeep on the Sea Ranch property themselves. Mr. Lucero drove to the Sea Ranch property approximately six to nine times each year to landscape, clean and inventory, and make and/or oversee any necessary repairs. In 2015, Mrs. Lucero accompanied him to help clean, decorate, and inventory. Some of those trips required one or both of them to stay multiple nights at the Sea Ranch property. They also stayed at the Sea Ranch property with family for approximately one week during Christmas each year.

Mr. Lucero prepared and filed timely his 2014 Form 1040, U.S. Individual Income Tax Return, and elected single filing status. Included with the return was a Schedule E on which he reported total rents received for the Sea Ranch property of $26,223 and expenses of $43,854 for a net loss of $17,631. He prepared and filed timely with his wife a joint 2015 Form 1040. Included with the return was a Schedule E on which the couple reported total rents received for the Sea Ranch property of $26,710 and expenses of $51,200 for a net loss of $24,490.

The Luceros' 2014 and 2015 tax returns were audited by the IRS. The Luceros did not keep any contemporaneous logs, calendars, or other documentation stating the number of hours they spent on activities related to the Sea Ranch property for the years at issue. Rather, Mr. Lucero created a log while the case was with the IRS Office of Appeals (IRS Appeals) that attempted to reconstruct, using invoices and receipts, the number of hours the couple spent on these activities. In that log, Mr. Lucero estimated that he spent a total of 267 hours on activities for the Sea Ranch property in 2014 and that he and his wife spent a total of 273 hours on activities in 2015. The activities included paying bills, buying supplies, performing maintenance and repairs, traveling between the couple's Sacramento home and the Sea Ranch property, coordinating with Sea Ranch Escapes, and preparing tax returns. The IRS issued notices of deficiency for both years disallowing any deduction for the Schedule E real estate loss for each year. The Luceros took their case to the Tax Court.

The IRS argued that the Luceros used the Sea Ranch property as a residence and a vacation rental for purposes of Code Sec. 280A rather than as a residential or business rental property and, thus, were not entitled to deduct their rental real estate losses related to the property. Under Code Sec. 280A, no deduction is allowed with respect to a dwelling unit used by the taxpayer as a residence during the tax year. A dwelling unit is considered to be a taxpayer's residence if its use for personal purposes exceeds the greater of 14 days or 10 percent of the days the unit is rented at a fair rental value in a tax year. A taxpayer is deemed to have used a dwelling unit for personal purposes when, for any part of a day, the taxpayer or any member of the taxpayer's family uses the unit for personal purposes or any individual uses the unit unless a fair rent is charged for the use. Days spent primarily repairing and maintaining the unit will not count toward personal use merely because other individuals on the premises are engaged in some other activity.

Analysis

The Tax Court rejected the IRS's Code Sec. 280A argument and instead held that the Luceros' real estate losses were not deductible because they were passive activity losses under Code Sec. 469. While the court was not convinced by Mr. Lucero's testimony regarding the total hours he spent maintaining the Sea Ranch property, it did accept his broader claim that most of his trips to the property were for upkeep. The court said that since it was accepting his testimony that every trip the Luceros made to the Sea Ranch property, other than at Christmas, was for repairs or maintenance, then the time they spent at the Sea Ranch property for personal purposes totaled fewer than 14 days in each year. Since the IRS had not disputed that the Luceros rented the Sea Ranch property to tenants for 146 days in 2014 and 152 days in 2015 or that the Luceros charged any of their tenants below-market rent, the Tax Court concluded that Code Sec. 280A did not limit any of the real estate loss deductions the Luceros could claim with respect to the Sea Ranch property for the years at issue.

The court noted that the Luceros' operation of the Sea Ranch property constituted an activity that was a trade or business under Code Sec. 469(c)(6) and a passive activity under Code Sec. 469(c)(1) unless they established material participation in the activity during the years at issue. Rental activity, the court observed, is ordinarily passive, regardless of whether the taxpayers materially participate in the activity. However, an activity that involves the use of tangible property is not a rental activity if the average period of customer use for such property is seven days or less in a tax year (i.e., a short-term rental). On average, the court said, the Sea Ranch property was used for short-term rentals in both of the years at issue, so the couples' short-term-rental activities were not rental activities under the statute.

The court therefore had to decide whether Mr. Lucero materially participated in the short-term-rental activities. Under Code Sec. 469(h)(1), material participation requires that a taxpayer be involved in the activity on a regular, continuous, and substantial basis and meet one of the seven tests set forth in Reg. Sec. 1.469-5T. The court rejected Mr. Lucero's contention that he met the test under Reg. Sec. 1.469-5T(a)(3) which requires that the individual participate in the activity more than 100 hours during the tax year and that his participation in the activity be not less than the participation of any other individual (including individuals who are not owners of interests in the activity) for the year. Mr. Lucero's argument relied on the time recorded in his logs that he reconstructed while under audit and which included time spent paying bills and preparing tax returns.

The court rejected this argument after noting that Reg. Sec. 1.469-5T(f)(2)(ii)(A) provides that work performed by an individual in his capacity as an investor in an activity is not be treated as participation in the activity unless the individual is directly involved in the day-to-day management or operations of the activity. The court found that the couple was not involved in the day-to-day management or operations of the Sea Ranch property because Sea Ranch Escapes managed and operating the property. Mr. Lucero's time spent paying bills, coordinating with Sea Ranch Escapes, and preparing tax returns, the court said, constituted investor activities that do not count toward the 100-hour requirement. The court also excluded the time Mr. Lucero spent driving between the Sea Ranch property and his Sacramento home because, absent any allocation between personal and business expenses, such expenses are personal. The court also found Mr. Lucero's activity log to be unreliable.

Finally, the court concluded that, even if it were to assume that Mr. Lucero spent 100 hours on short-term rental activities during 2014 and 2015, the record did not include any documents showing the number of hours other individuals, such as Sea Ranch Escapes, spent on those activities in connection with the Sea Ranch property.

For a discussion of the passive activity loss rules with respect to 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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