The tax law allows real investors to write off a portion of their losses from rental activities, or even the full amount, if they meet certain requirements. However, as shown in a new case, Foradis, TC Summ. Op. 2024-13, 7/11/24, it’s difficult to convince the Tax Court you’ve put in the necessary time—especially if you have another full-time job.
Background: Normally, investors in passive activities in which they don’t “materially participate,” like most real estate activities, can take deductions only up to the amount of their passive income for the year. Thus, they can’t claim any annual passive activity losses (PALs), although there a limited write-off is allowed for certain real estate investors. Under this exception, you can use up to $25,000 of loss to offset non-passive income if you meet the definition of an “active participant.” But the $25,000 offset is phased out for a modified adjusted gross income (MAGI) between $100,000 and $150,000.
Conversely, if your real estate activities rise to the level of being a real estate professional, you can deduct losses in full against non-passive income, just like any other business. There are three key requirements for qualifying as a real estate professional.
1. You “materially participate” in real property trades or businesses.
2. You spend more than 750 hours on your real property trades or businesses.
3. The hours spent on real property trades or businesses are more than half of all the hours that you put into all your business activities.
The third requirement is the one that tripped up the taxpayer in the new case.
Facts: A husband, who filed a joint return with his spouse, reported taxable wages of $161,000 in 2020, including $78,000 for himself. He also reported real estate rental activity from a carriage house they built in 2020. On their 2020 return, he claimed a net loss of more than $22,000 from the carriage house activities against their non-passive income.
For starters, the IRS said the couple didn’t qualify for the partial offset for an active participant because they exceeded the dollar threshold. So, they tried the second approach: The couple claimed that the husband qualified as a real estate professional.
In 2020, the husband worked full-time, 40 hours per week, while taking two weeks off for personal time. Accordingly, to prove that he spent more than half of his time on real estate activities, he would have to show spent more than 2,000 hours on real estate activities.
The husband claimed that he actually logged 2,500 hours during 2020 working on construction and other matters relating to the carriage house—well above the threshold. He said that he did this work after his regular job, on weekends and during the two-week vacation. He provided logs and receipts to support his position and relied heavily on his own testimony. But the Tax Court wasn’t buying it.
Conclusion: The tax court judge figured out that the husband would have had to work 40 hours at his regular job and 48 hours a week on the real estate activity. That lefty only about 80 hours a week for sleeping. eating, cleaning, bathing, sleeping commuting and all the other facets of human life—an average of about three hours a day after sleep. That seemed “implausible” to the judge.
Result: The husband didn’t qualify as a real estate professional.
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Tags: Taxes
