Do you meet the requirements to be classified as a real estate professional for rental property tax deductions?

Taxpayer Not a Real Estate Professional, Most Hours in Rentals Found to Be Investor Activities –  A summary of a recent tax ruling:

The taxpayer in the case of Padilla v. Commissioner, TC Summary Opinion 2015-38 did not fall into the traps that have caused other taxpayers to lose their cases claiming to be a real estate professional and deducting losses arising from their rentals. But he found himself trapped by a different problem.

Taxpayers attempting to claim to meet the requirements to be treated as a real estate professional must show, under IRC §469(c)(7)(B), that:

  • More than ½ of the personal services performed by the taxpayer in a trade or business for the year was performed in real property trades or businesses in which the taxpayer materially participates, and
  • The taxpayer performs more than 750 hours of service in such real property trades or businesses during that year.

The taxpayer is responsible for having records to prove these contentions which will also require showing how many hours the taxpayer spent on other, non-real estate, trade or business activities.

Mr. Padilla had records showing that he had performed 676 hours in his non-real estate employment in the year in question, having lost his job in April of that year and not having obtained another before year-end. Because of this extra time available due to no longer having a full-time job and the overall economic downturn that was impacting his rental properties, he spent more time in trying to refinance his rentals and in other activities related to the property. He reported 764 hours working in the rental activity.

At first glance this appears to put Mr. Padilla in a good position—he had fewer hours in his non-real estate businesses, albeit due to being involuntarily terminated, than in the real estate one. And he had support for spending more than 750 hours in real estate.

The Court found that Mr. Padilla’s log, along with his testimony, would generally suffice to clear the 750 hour hurdle and all parties conceded his time at his job prior to being terminated was 676 hours.

However, when looking into those real estate hours in more details the Court found a problem—many of them were activities of an investor, which will not count towards material participation under the passive activity rules. Per Reg. §1.469 5T(f)(2)(ii)(A) such work is not generally treated as participation in an activity.

Most of the hours for each month were in the following generic categories: research properties near properties already owned; refinance research; foreclosure research (which appears to be considering properties that could be purchased); and researching new businesses.

Petitioner hired a management company to manage the four Texas properties. Additionally, he hired a real estate company to find tenants and lease the San Francisco property. Accordingly, the petitioner had relatively little personal involvement in the operation of the rental real estate activity that was regular, continuous, and substantial.

With those hours out of the list, Mr. Padilla falls far below the 750-hour requirement to be a real estate professional. Therefore any losses on his real estate properties must be treated as passive activity losses under the general rule that rental activities are passive pursuant to IRC §469(c)(2).

Are you a Real Estate Owner or a Real Estate Professional?   – Do you meet the requirements to be classified as a real estate professional for Rental Property Tax Deductions? Need help in making sure you are filing correctly?  We can help.  Call us at 732-531-8000, ext. 225 and ask for Sal Schibell! [email protected].  Lawson, Rescinio, Schibell & Associates, P.C. has experience with all types of tax issues.