United States

Court upholds 20 percent penalty on misclassification of real estate professional


In a summary opinion, a tax court ruled that a taxpayer was liable for the 20-percent accuracy-related penalty after failing to qualify as a real estate professional (Nicholas S. Farris et ux. v. Commissioner, TC Summ. Op. 2015-53). Although this case has no precedential value, it is nonetheless interesting to note the court’s willingness to uphold the accuracy-related penalty despite facts that do not appear egregious.

The taxpayer in question was involved in two businesses – (1) she was a part-time employee (not a real property trade or business), and (2) she and her husband owned two rental real estate properties. During the exam process, the taxpayer asserted that she spent 1,040 hours as a part-time employee and 852 hours performing services in the rental real estate business. However, later in the exam process her husband provided a revised hour log indicating that they collectively spent 1,254 hours on their real estate activities (most of which apparently related to the wife).

The change is important because in order to qualify as a real estate professional, more than 50 percent of a taxpayer’s personal services must be attributable to real property trades or businesses (there are additional requirements, but those were not at issue in this case). The taxpayer and her husband apparently prepared both the initial log showing 852 hours and the subsequent log showing 1,254 hours based on notes they took at or around the time they performed the services.

In the decision, the court expressed skepticism regarding the taxpayer’s assertion that she only spent 1,040 hours as a part-time employee. It went on to note that even if the taxpayer’s estimate was accurate, she would fail the real estate professional test based on the initial estimate of 852 hours spent in the rental real estate activities. The court proceeded to discount the subsequent log by indicating that it lacked proper substantiation by contemporaneous verification or other reasonable means. . . .

"[W]e are not required to accept postevent ‘ballpark guesstimates’, nor are we bound to accept the unverified testimony of taxpayers in the absence of adequate documentation."

Although the taxpayer did indicate that the logs were based on contemporaneous notes, she apparently did not provide those notes to the court. It is unclear whether the decision might have been different had she done so.

Qualifying as a real estate professional has been important to those in the real estate profession for years – doing so means that the taxpayer is not subject to the general rule that rental income is per se passive regardless of the taxpayer’s level of activity. But qualifying as a real estate professional has taken on greater significance recently with the introduction of the 3.8 percent net investment income tax. This case serves as a reminder that documenting participation is critical to substantiating this position.

But the fact that the court was willing to uphold the 20-percent accuracy-related penalty in this case makes the reminder even more important. The government has the initial burden with respect to imposition of the penalty. The case did not involve a substantial understatement of tax, so the government was required to demonstrate that the understatement was due to the taxpayer’s negligence or disregard of rules or regulations. The court indicated that the government met this burden simply by demonstrating that the taxpayer failed to keep accurate records. The court then dispatched with the reasonable cause and good faith defense by noting that the taxpayer provided no evidence that she gave her tax preparer all the necessary information, such as records substantiating the time spent in the rental activities.

Taxpayers should view this decision as a reminder regarding the importance of documenting participation with contemporaneous notes, and a warning that failure to do so could expose a taxpayer to additional tax and a 20-percent penalty.



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