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September 12, 2006

It's never a good sign when your judge starts mocking you. Two brothers pushed the Tax Court to the edge of mockery in a case decided yesterday, and they can't be liking the results.

The brothers - Ulysses and Kai Lee - were partners in a partnership that owned three rental properties - a single family home and a five unit apartment building in California, and a small rental property in Hawaii. Kai also owned two other single-family units and a three-plex in his own name; Ulysses other owned a four-plex personally.

The properties generated a tax loss. The tax law has a "per-se passive" rule that treats rental income and loss as "passive"; passive losses are deductible only to the extent of passive income, with net losses carried forward to offset future income until the property is sold.

The "per-se passive" rule has one out: if you are a "real estate professional" and you "materially participate"* in the real estate activities, you may deduct the real estate losses losses. In order to be a "real estate professional," you have to clear two high hurdles:

1. You have to spend at least 750 hours per year in real estate activities, and

2. You have to spend more time on your real estate businesses than you do on your non-real estate businesses.

If you have a full-time job that's not in real estate, this test is nearly impossible to pass - it's tough to work 2,000 hours in your regular job and then 2001 hours on the side. Yet the Lee brothers did their best to convince the Tax Court that they did just that.

They didn't do very well.

First, both brothers had full-time jobs. One was a full-time radiology professor; the other was... an IRS agent!

The brothers presented "reconstructed" logs of the time spent on the activities. The judge wasn't buying:

...the logs introduced at trial are packed with too much exaggeration to be believed. Here are a few examples from Ulysses':

* 280 hours each year to close the books and prepare information about the partnership for he and his brother to use in completing their tax returns.

* 80 hours in 2000 preparing for an IRS audit because the partnership's records were in such disarray, despite his 280 hours of work in closing the books. (The audit of the 2000 returns, of course, did not actually take place in 2000.)

* 24 hours to replace four miniblinds in one of the apartments, 42 hours to paint another, and 56 hours to install a new toilet in a third.

* 186 hours in 1999 to show a single vacant apartment to prospective tenants.

* 200 hours of answering calls from prospective tenants in both years.

* 48-50 hours to wrap coins from laundry machines in one of the apartment buildings.

24 hours to replace four miniblinds? Wow. I thought I was a poor home handyman, but I can't touch Ulysses.

The brothers didn't just rely on spending a lot of time on their real estate business. They also tried to convince the judge they were shirkers at their regular jobs:

But because the brothers had to show not only the time they spent on partnership business, but that it was greater than the time they spent on other jobs, the exaggeration in their logs of real estate work was matched by understatements of time spent at their full-time jobs. Ulysses calculated his hours spent working for the IRS by deducting his sick leave and vacation from a full-time schedule. But the Commissioner introduced time and attendance records from the IRS, showing that Ulysses hadn't used all his available sick and annual leave. This forced him to take the dubious position that he routinely filled in his own time-and-attendance records inaccurately.

Oops! It's a good thing that Ulysses has retired from the IRS; this would have resulted in an interesting performance review.

Kai Lee's testimony on this point was no better. He swore that he worked for the corporation that he owned -- a corporation that produced more than $60,000 in gross receipts for both years -- only 37 hours in 1999, and 3 hours in 2000.

If he grossed $60,000 in revenue with only 37 hours of work, that works out to $1621.62 per hour. Had he spent the 2,000 hours he squandered on the real-estate working for his regular business, he should have grossed $3,243,000 or so, at that hourly rate. Talk about poor time management!

The judge sticks the needle in a little more:

The credibility of the brothers' testimony was undermined even when it touched on other areas. For instance, when asked on cross- examination whether he knew anything about what an IRS appeals officer does, Kai Lee responded: "I don't know any IRS people." His brother Ulysses, who had just retired from his career as an IRS examiner, was sitting at petitioners' table with him at the time.

Ouch. Hey, judge, am I my brother's keeper?

The result, predictably, was for the IRS, including an assessment of accuracy-related penalties.

Cite: Lee, T.C. Memo 2006-193.

*A review of the material participation rules is in the extended entry below.


The tax regulations say you achieve "material participation" in for a tax year if:

-You participate at least 500 hours in one activity; or
-You participate at least 100 hours and at least 500 hours in more than one "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

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Perhaps these guys should go back to law school. There's probably a few law firms out there that would appreciate their, ahem, creative time billing skillzz. Fer shizzle.


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