As we’ve discussed previously, rental real estate activities are considered passive by default are passive activities, and in general, losses may only offset passive income. Unless, that is, you qualify as a “real estate professional” under Section 469(c)(7), in which case you can deduct rental losses in full against nonpassive income.
In order to qualify as a real estate professional, a taxpayer needs to pass two tests under Sec. 469(c)(7)(B), with a plain English interpretation in the ensuing parenthetical)
(1) more than one half of the personal services performed by the taxpayer in all trades or businesses for the tax year must be performed in real estate trades or businesses in which the taxpayer materially participates (you must spend more hours on real estate activities than non-real estate activities), and
(2) the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. (you must spend more than 750 hours in each real estate activity, unless you elect to group them in which case you must spend more than 750 hours on the combined real estate activities)
Straightforward as these tests may seem, they’ve generated an inordinate amount of litigation given the relatively young life of Section 469(c)(7). In just the past month, the Tax Court has twice ruled against taxpayers claiming real estate professional status, repeating a line of reasoning seen time and time again; a line of reasoning we can all stand to learn from.
In Anyika v. Commissioner, the taxpayer worked 1,800 hours as a full-time engineer. In his spare time, he purchased, renovated, managed and sold rental properties. The Tax Court disagreed with Anyika’s contention that he qualified as a real estate professional. In reaching its decision, the court noted that the taxpayer failed to prove he worked more than 1,800 hours on his real estate properties, and thus did not satisfy the first prong of the Section 469(c)(7) test.
Similarly, in O’Connell v. Commissioner, T.C. Summary Opinion 2011-43, the Tax Court denied real estate professional status to a taxpayer who couldn’t prove he spent more time on his two rental properties than the 1,250 hours he spent as a financial analyst.
So what can we learn from Anyika and O’Connell?
First and foremost, if you’ve got a full-time job outside of real estate, it’s going to be difficult to pass the first test of Section 469(c)(7). It’s strictly a numbers game: if you spend 40 hours a week pushing papers, can you reasonably spend 41 hours a week managing your rental properties?
Secondly, it’s not enough to simply claim you spend more hours on your real estate properties than your day job; you’ve got to be able to prove it. Many cases fall flat because of the failure of the taxpayer to document their involvement in the real estate activities. While the IRS will look at other incidental evidence of participation (date books, calendars, etc.) taxpayers should be sure to accurately and completely document the hours spent on the real estate activities in order to substantiate the participation. While the IRS does not require a contemporaneous log of hours spent, they frown on estimates made after the fact.
Lastly, the second test of Section 469(c)(7) – requiring the taxpayer to spend more than 750 hours per year in real property trades or business in which the taxpayer materially participates — also poses a serious challenge. Absent an election to group the activities under Sec. 469(c)(7)(A), you will have to spend more than 750 hours in each rental activity. Obviously, this provides tremendous motivation to group your activities, but keep in mind, this election is binding for all future years unless there is a material change in facts and circumstances.