Taxpayers Don’t Qualify for PAL Exception for Rental Real Estate

The Supreme Court has refused to review the outcome of a new case where a taxpayer was limited by the passive activity loss (PAL) rules. The taxpayers claimed that they qualified under an exception for “extraordinary personal services” for rental properties, but the Fourth Circuit Court denied the loss deduction (Johnson v. Pope, 117 AFTR2d 2016-947, cert denied 10/3/16).

For starters, losses from passive activities can only offset income earned from other passive activities. Any excess passive loss is suspended. Generally, a passive activity is an undertaking involving a trade or business in which you do not “materially participate.” This rule requires participation in the business activity on a “regular, continuous and substantial” basis as determined by IRS regulations. For example, you’re treated as a material participant if you work more than 500 hours a year on the activity.

Notably, rental real estate activity is treated as a passive activity, but an “active participant” in the activity may use up to $25,000 of loss to offset non‑passive income, subject to a phase-out for investors with an annual adjusted gross income (AGI) between $100,000 and $150,000. Note that the “active participation” test is more rigorous than the “material participation” test. You’re really must be hands-on in day-to-day affairs.

Under another exception, a taxpayer involved in a rental activity may avoid the PAL limits if others provide “extraordinary personal services” in connection with making the property available for use. The use must be incidental to the personal services. For instance, use by students of a private school’s dormitories may be incidental to the personal services provided by the teachers.

In the new case, two taxpayers deducted losses they had incurred in 2006 and 2007 for three rental properties. They claimed that they provided extraordinary personal services in connection with these properties. This included providing occupants of their rental properties with recreational activities such as fire and horseshoe pits, satellite television service, kitchen dishes and appliances, furniture, cleaning supplies and periodic household services, landscaping, bathroom toiletries, laundry facilities and continental breakfast items.

However, the district court in North Carolina concluded that landlords commonly provided these types of services. Thus, they did not qualify for the exception for extraordinary personal services.

The taxpayers also argued that one of the owners provided counseling services to their residents upon request. This encompassed legal, tax, financial and psychological counseling. But they didn’t offer sufficient proof to substantiate this claim for the exception.

The Fourth Circuit Court went along with the district court and sided with the IRS. Now that the Supreme Court has declined to revisit the matter, the case is closed.

Be mindful of the PAL rules as they apply to your clients who own rental real estate properties. By qualifying under one of the tax law exceptions, they may be able to deduct losses, or at least a portion of losses, in excess of passive income for this year.