Over the next seven days, as you prepare to deduct large rental losses on your tax return under the premise that you are a “real estate professional,” it’s prudent to remember that just because you may work in the real estate field as a broker or agent, it doesn’t guarantee that you satisfy the statutory definition of a real estate professional for each of your activities.
Consider the case of Nerissa Manalo (“Manalo”). Manalo worked as a real estate broker and also owned two rental properties. The rental properties generated large losses during 2007 and 2008, which Manalo deducted in full on her tax return.
Now, in general, rental real estate activities are de facto “passive;” thus, they can only be deducted to the extent they offset other passive income.[i]
The statute provides an exception in I.R.C. § 469(c)(7), allowing a “real estate professional” to treat their interest in a rental activity as nonpassive.
In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B). The taxpayer must satisfy both of the following tests:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates.
- Such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
The underlined text is meant to highlight that even if a taxpayer clearly works in the real estate field, they must materially participate in the activities being considered. Importantly, an individual may establish the extent of their participation — specifically, whether they meet one of the seven tests enumerated under the I.R.C. § 469 temporary regulations — by any “reasonable means.”[ii] The Tax Court has held that the phrase “reasonable means” does not include a post event “ballpark estimate.
In deducting the rental losses in full, Manalo took the position that she met these requirements and qualified as a real estate professional. The IRS, however, had a different opinion.
The Service audited Manalo’s 2007 and 2008 tax returns, challenging the rental losses. During the examination, Manalo submitted a log of hours spent on her rental activities that was not kept contemporaneously, but rather was re-created from her desk calendar, which detailed her various appointments.
Between the start of the audit and the trial, Manalo submitted three revised versions of the original log to the IRS. These logs were based on emails and archived documents that were not introduced into evidence.
The Tax Court held that Manalo did not satisfy her burden of proving that she materially participated in the rental properties, as she failed to establish her time spent using “reasonable means.”[iii]
We find overall, however, that the means by which petitioners estimated the time they spent performing services in their rental real estate activities were not reasonable…The estimates in these revised logs, however, are uncorroborated and unreliable. The revised logs were prepared at various instances over a two-year period after the conclusion of respondent’s examination and are, according to petitioners, based on emails and archived documents. Those emails and archived documents, however, were never introduced into evidence at trial. “The rule is well established that the failure of a party to introduce evidence within his possession and which, if true, would be favorable to him, gives rise to the presumption that if produced it would be unfavorable.”
The estimates on the revised logs appear to be more akin to the unacceptable ballpark guesstimates that we have rejected in the past.
The lesson, of course, is that accurate, contemporaneous records are key to successfully claiming real estate professional status. Throughout the relevant case history, more claims under I.R.C. § 469(c)(7) have been derailed by sloppy records than every other IRS argument combined
[i] Ignoring the limited “active participation” exception allowing taxpayers with AGI < $150,000 to deduct up to $25,000 in losses from rental activities.
[ii] Treas. Reg. §1.469-5T(f)(4).
[iii] Presumably, if Manalo had election to group her rental activities together as provided for in I.R.C. § 469(c)(7)(A)(ii) flush language, she may have had a better shot at proving material participation.