Tax Court denies taxpayer’s loss on real estate activities
Taxpayer lacked credible evidence to support hours spent on activities
TAX ALERT |
On April 17, 2017, the Tax Court concluded in Penley v. Commissioner, TC Memo 2017-65, that the taxpayer did not sufficiently substantiate time spent in his real estate activities to qualify as a real estate professional. As a consequence, the losses incurred in his rental activities were passive losses. The case is a good reminder that courts will give weight to contemporaneous documentation of a taxpayer’s activities, and they can also be skeptical of documentation amounting to post-event ‘ballpark guesstimates.’
Taxpayers generally cannot deduct net losses from passive activities, including rental real estate activities. However, an important exception exists for qualified real estate professionals—individuals who (a) devote over one-half of their personal services in a particular year to real property trades or businesses, and (b) perform more than 750 hours of services in those real property trades or businesses. Such taxpayers can deduct losses from their rental real estate activities to the extent they materially participate in that activity. There is often contention, however, between taxpayers and the IRS with respect to the substantiation of hours necessary to qualify as a real estate professional. That was the issue in this case
The taxpayer in question held a full-time job and was a licensed real estate broker. He conducted real estate activities through an S corporation and owned other real estate in his own name. On his 2012 individual income tax return, the taxpayer asserted that his time spent on his real estate activities was enough to qualify him as a real estate professional. He deducted losses from his rental real estate activities on his 2012 tax return. The taxpayer provided some documentary evidence of his activities, including a monthly calendar indicating the property where he worked, a brief description of his activities, and an estimate of the hours he worked on that date. The IRS denied the deductions, concluding that the taxpayer’s evidence to support his claim that he spent 2,520 hours on his real estate activities was unconvincing, particularly when he also had a full-time job in which he likely worked in excess of 2,000 hours.
The court acknowledged that taxpayers can establish their participation ‘by any reasonable means,’ a term that does not necessarily require contemporaneous hour logs. The court did emphasize, however, post-event ballpark guesstimates are not sufficient. Instead, taxpayers should be relying on contemporary evidence—such as appointment books, calendars or narrative summaries—that will enable them to compile sufficient evidence that they have satisfied the hour requirements of a qualified real estate professional.
There are several lessons that this case highlights that taxpayers should keep in mind as they think about documenting their participation:
- Contemporaneous hour logs are not required, but contemporaneous evidence (calendars, datebooks, etc.) that contain sufficient and credible detail to allow the taxpayer to later compile the hour log will be important.
- Taxpayers who maintain no evidence of their activities and instead plan to wait until an IRS inquiry, will have a very difficult time sustaining their position. Courts continue to emphasize that post-event ballpark guesstimate are not sufficient.
- In order to qualify as a real estate professional, a taxpayer must devote more than half of his or her personal services to real property trades or businesses. In situations where a taxpayer has a full-time job that is unrelated to those real property businesses, it will be very difficult to convince the IRS that a taxpayer can satisfy that requirement.