In an episode of the short-lived but brilliant sketch comedy “Chappelle’s Show,” Dave Chappelle is asked by a prosecuting attorney what it would take for Dave to admit that it is in fact R&B singer R. Kelly participating in a particularly…uhh…incriminating video. While Dave admits he can be persuaded, it’s going to take some work:
Prosecutor: Mr. Chappelle, what would it take to convince you that R. Kelly is guilty?
Dave Chappelle: Okay, I’d have to see a video of him singing “Pee On You,” two forms of government ID, a police officer there to verify the whole thing, four or five of my buddies and Neal taking notes, and R. Kelly’s grandma to confirm his identity.
What’s the point? Based on the relevant case history — and highlighted again today in Prang v. Commissioner,[i] — if you’re going to successfully claim that you qualify as a “real estate professional” pursuant to I.R.C. § 469(c)(7), you’d better be prepared provide just as much convincing evidence to the IRS.
Not to beat the issue to death, as we’ve discussed it here, here and here, but losses from a rental activity are de facto passive under I.R.C. § 469. As a result, taxpayers may generally only deduct rental losses to the extent of any passive income.
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.
In Prang, as has been the case many time before, the taxpayer never even earned the chance to satisfy these numerical tests, because they failed to maintain detailed, accurate, and contemporaneous records.
The IRS finds its ammunition in Treas. Reg. §1.469-5T(f)(4), which provides:
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
In Prang, the taxpayer split her time during 2006 between working as a chiropractor and seeking out real estate investments. While she kept logs detailing her hours spent in both activities, they proved useless to the Tax Court. With regard to the chiropractic log, the Tax Court explained:
We are unable to determine the number of hours Ms. Prang spent in her chiropractic business because the appointment book is not credible. Many of the patient visits and notes are illegible. The daily total frequently does not reconcile with either the number of patients scheduled for the day or the amount of time it appears Ms. Prang was working. We would have to engage in complete guesswork to determine how much time Ms. Prang spent at her chiropractic business on a particular day during 2006, let alone the entire year. We decline to engage in such dubious speculation.
The real estate log proved equally unreliable, for three reasons. First and foremost, they were not prepared contemporaneously:
The handwritten notes explaining Ms. Prang’s activities were written in pen while the associated hours were written in pencil on the side of the page. Petitioners testified that this was done so Ms. Prang could cross-reference her recorded times with her phone records and make adjustments. While this may be true, it does not explain why most of the hours are recorded as whole numbers and occasionally multiple time entries are reported for the same activity.
Perhaps more damning to Prang’s argument, however, was the Tax Court’s belief that the hours spent on simple tasks were grossly overstated, bringing into question the credibility of the records:
Secondly, in several circumstances the number of real estate hours reported appears excessive in relation to the task described. After renting the Milpitas property for approximately 10 years, Ms. Prang reports she spent two hours every month (three hours in April) throughout 2006 depositing the rent check, mailing the mortgage payment, and making the associated bookkeeping entries. The real estate log is also filled with unreasonable assertions of time spent exchanging emails. Moreover, the Louisiana section reports that on November 2, 2006, Ms. Prang spent an hour reading a five-sentence email.
Lastly, the court found it hard to believe that Prang put in the herculean efforts she claimed, discounting Prang’s assertion of 17-hour and even 19-hour days.
Moreover, comparing petitioners’ time entries from the various real estate log sections further illustrates that the time entries were excessive and not credible. Perhaps the most suspect entries relate to Ms. Prang’s trip to Alabama…Ms. Prang reports that she left her hotel at 8 a.m. to meet with “Keith from T&K Construction” and visit some properties. She reports she spent eight hours visiting properties and then two hours back at her hotel conducting more research. However, according to the Alabama section, she also met with “Cricket” at 4 p.m. that day to “set up some properties to look at tomorrow” and then she decided to “tour the area to get a feel for locations of schools, shopping, business/employment”. Petitioners report four hours associated with these activities. Finally, according to the Louisiana section, Ms. Prang also managed to spend an additional five hours receiving an inspection report and sending a punch list to Stacie, concluding her 19-hour day.
The fact that Prang’s records were overstated, illegible, and not done on a contemporaneous basis ultimately led the Tax Court to conclude — as it has many times before — that Prang could not prove she was a real estate professional, even if her “records” satisfied the two-prong numerical test.
While Ms. Prang may have invested a considerable amount of time in real estate activities during 2006, petitioners’ records are simply too unreliable for us to draw any sound conclusion. We are unpersuaded that during 2006: (1) Ms. Prang spent more than one-half of her personal services in real estate activities; and (2) Ms. Prang performed over 750 hours in real estate activities. Therefore, we conclude that petitioners do not meet the requirements of section 469(c)(7)(B), and petitioners’ rental activities in 2006 are treated as per se passive under section 469(c)(2).
The lesson is obvious. Unless you’re prepared to present contemporaneous and meticulously detailed logs to the IRS, you’re best off not even bothering to claim “real estate professional” status
[i] T.C. Memo 2012-165