Passive Loss Rules- IRS Audit Appeals Outcome

Passive Loss Rules- IRS Audit Appeals Outcome

Savings: $65,545

Passed on Real Estate Professional- Failed on material participation

Individuals who participate in passive activities may be limited in the amount of losses and credits that they may claim on their income tax returns. Under Temp. Regs. Sec. 1.469-1T(e)(1), an activity is classified as passive if the activity is (1) a trade or business activity in which the taxpayer does not materially participate during the year or (2) a rental activity.

Income and losses arising from any rental activity are generally considered passive. One exception to this rule applies to real estate professionals: “If the taxpayer qualifies as a real estate professional, the taxpayer’s rental real estate activity escapes the per se rule otherwise applicable to rental activity.”

A taxpayer will be considered a real estate professional if (1) more than one-half of the total personal services the taxpayer performs in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.  

To avoid the classification of an activity as passive, taxpayers engaged in the rental of real estate must overcome two hurdles. First, the taxpayers must establish that they qualify as real estate professionals to avoid the general rule that all rental activity is per se passive. Second, if the taxpayer qualifies as a real estate professional, the taxpayer must establish that the taxpayer materially participated in the rental real estate activity. If the taxpayer does not meet both of these requirements, any losses that arise from the rental activity will be considered passive and will be subject to the passive activity loss limitation.

Material Participation Test Under the Temporary Regulations

Temp. Regs. Sec. 1.469-5T(a) provides that a taxpayer can establish material participation in an activity by satisfying one of seven tests:

1. The individual participates in the activity for more than 500 hours during such year;
2. The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
3. The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
4. The activity is a significant participation activity (within the meaning of [Temp. Regs. Sec. 1.469-5T(c)]) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;
5. The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
6. The activity is a personal service activity (within the meaning of [Temp. Regs. Sec. 1.469-5T(d)]), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
7. Based on all of the facts and circumstances (taking into account the rules in [Temp. Regs. Sec. 1.469-5T(b)]), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

A taxpayer bears the burden of establishing material participation by reasonable means. To prove that a taxpayer may not have materially participated, IRS agents are directed in passive activity cases to “look for time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc.”

To meet the seventh test under Temp. Regs. Sec. 1.469-5T(b)(2)(iii), the facts-and-circumstance test, the taxpayer must participate in the activity for at least 100 hours. And, under Temp. Regs. Sec. 1.469-5T(b)(2)(ii), the taxpayer’s services performed in management activities are not taken into account in determining whether he or she materially participates unless (1) no person other than the taxpayer receives compensation for those services and (2) no person performs management services for more hours than the taxpayer.

In our appeal case the Auditor accepted that the spouse was consider a “Real Estate Professional” but denied the case based upon material participate, which she said did not add up to 500 hours.  In the appeals case we pointed out that the 500-hour rule was only one of the seven material participation tests.  We made our case using the 3rd test for material participation;

The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year. 

We were able to prove, leaning a bit on the Pohoski case, that the taxpayer participated for 100 hours, and no other person participated in the activity more than the taxpayer. 

Great Outcome, saved the taxpayers $65,545