Taxpayer Qualified as Real Estate Professional; Rental Losses Not Limited by PAL Rules

(Parker Tax Publishing September 2018)

The Tax Court held that a taxpayer who managed two rental real estate units was not precluded by the passive activity loss (PAL) rules from deducting losses from the real estate activities in excess of the passive loss limitation amount because she qualified as a real estate professional. The court found that the taxpayer was not otherwise employed in the year at issue and that two spreadsheets she produced established that she spent over 750 hours on the activity, even though parts of the spreadsheets were not created contemporaneously but rather reconstructed based on the taxpayer's calendar and receipts. Birdsong v. Comm'r, T.C. Memo. 2018-148.

Background

During 2014, Roberta and William Birdsong owned two rental real estate properties consisting of four and five rental units, respectively. Mr. Birdsong worked full time as an emergency physician. Mrs. Birdsong split her time between caring for their children and managing the rental properties.

In 2014, Mrs. Birdsong was the only person actively involved in the daily management of the properties. Her tasks included cleaning common areas, collecting coins from the washing machines, performing repairs at the properties, communicating with tenants, collecting and depositing rent, maintaining insurance policies, purchasing materials, paying bills, and keeping books and records for tax accounting purposes. Mrs. Birdsong occasionally hired a contractor to perform tasks she could not complete herself. When she hired a contractor, Mrs. Birdsong spent considerable time researching and contacting contractors, obtaining price quotes, and supervising repairs. Mrs. Birdsong's management duties also included inspecting units, preparing units (painting and supervising contractors) for rental, advertising empty units, screening potential tenants, showing the units, and processing rental applications.

Mrs. Birdsong produced two spreadsheets detailing her rental management activities. The first spreadsheet showed that she logged 844 hours managing the properties in 2014, while the second spreadsheet showed a total of 1136 hours. The second spreadsheet included previously omitted time spent on the properties. The Birdsongs used Mrs. Birdsong's calendar and receipts to reconstruct the time entries on both spreadsheets for the first half of 2014. For the second half of the year, the time entries came from a contemporaneous log Mrs. Birdsong kept on her phone where she entered the date, location, time, and description of each task. Mrs. Birdsong had receipts and invoices that substantiated the hours she logged.

The Birdsongs hired a CPA to prepare their tax return for 2014 and other years. They reported a loss for their rental real estate activities on Schedule E, Supplemental Income and Loss, on the basis of Mrs. Birdsong being a real estate professional. Under Code Sec. 469(c)(7)(A), the Birdsongs elected to treat all of their rental real estate interests as a single activity. In 2016, the IRS issued a notice of deficiency disallowing the Schedule E rental real estate loss in excess of the Code Sec. 469 passive activity loss (PAL) limitation. The adjustment resulted in a deficiency of over $44,000 and an accuracy related penalty of $8,800. The Birdsongs filed a petition with the Tax Court for redetermination.

Analysis

Deductions are allowed for certain business and investment expenses under Code Secs. 162 and 212, but Code Sec. 469 generally disallows passive activity losses. A passive activity is any trade or business in which the taxpayer does not materially participate, and a passive activity loss is the excess of the aggregate losses from all passive activities over the aggregate income from all passive activities for the year.

Rental activities are generally treated as per se passive activities, regardless of whether the taxpayer materially participates. However, under Code Sec. 469(c)(7), rental activities of real estate professionals are not per se passive activities, but are treated as a trade or business subject to the material participation requirements in Code Sec. 469(c)(1). A taxpayer qualifies as a real estate professional, and is not engaged in a passive activity, if (1) more than half of the services performed by the taxpayer are real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of real property services during the year.

A taxpayer may establish the hours of participation by any reasonable means. Contemporaneous daily time logs are not required if the extent of the participation can be established in other ways. Reasonable means includes identification of services performed and the approximate number of hours spent performing such services based on appointment books, calendars, or narrative summaries. However, the Tax Court has held that a post-event ballpark estimate is not permitted.

The IRS conceded that Mrs. Birdsong satisfied the first prong of the real estate professional test because she was not otherwise employed in 2014. But the IRS argued that Mrs. Birdsong failed to establish that she met the 750-hour requirement because her logs were not contemporaneous and contained inaccuracies.

The Tax Court held that the Birdsongs' rental real estate losses were not limited by the PAL rules because Mrs. Birdsong materially participated and was a real estate professional. The court found that the Birdsongs' credible testimony and time logs were reasonable means of proving the amount of time Mrs. Birdsong spent on the rental real estate activities. In the court's view, Mrs. Birdsong testified credibly and in detail about her active and extensive management of the rental properties. The court also found that the Birdsongs presented detailed spreadsheets which showed that Mrs. Birdsong's rental management activities exceeded the 750-hour requirement.

The court explained that it found the Birdsongs' narrative summary and thorough time logs convincing because the Birdsongs owned numerous rental units that Mrs. Birdsong operated alone. The court also found that the Birdsongs' position was supported by receipts and invoices that corroborated the time logs. However, in a footnote, the Tax Court cautioned Mrs. Birdsong to construct more strictly contemporaneous time logs for her future endeavors.

For a discussion of the deductibility of rental real estate losses by real estate professionals, see Parker Tax ¶247,120.40.

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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