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PASSIVE LOSSES: MARK YOUR CALENDAR (CAREFULLY)

November 14, 2007

A Tax Court case issued yesterday illustrates how hard it can be to get around the anti-taxpayer tilt of the "passive loss rules." These rules were enacted in 1986 to shut down the retail tax shelter industry by limiting your ability to deduct losses from businesses you don't actually work for.

Limits on real estate losses are key to the passive loss rules. For most taxpayers, any losses from real estate are automatically "passive," so you can't use real estate rental losses to offset your salary or interest income. There are two important exceptions to this rule:

- If you "actively" participate in a rental activity, you can deduct up to $25,000 of real estate losses; your ability to deduct these losses begins to phase out when adjusted gross income reaches $100,000, and disappears completely at $150,000 AGI.

- If you are a "real estate professional," you can deduct rental real estate losses if you "materially participate" in the real estate activity. To be a real estate professional, you have to spend 750 or more hours annually in the real estate business, and you have to spend more time in real estate than in any other business activity (a more complete discription of "material participation" is at the bottom of this post).

The $186,487 part-time job

Carolyn Fenderson worked for Symantec, the software company, in 2002. The Tax Court describes her job:

In 2002 petitioner's compensation from Symantec totaled $186,487. Some of the commissions included in that amount relate to sales of software licenses made in years prior to 2002. According to petitioner, she spent about 15 hours a week working for Symantec during 2002. She maintained a calendar that tracked her activities and appointments in connection with her employment at Symantec, which ended during 2003.

Ms. Fenderson, by her own account, was busy in 2002, operating 10 residential real estate properties. She claimed "real estate professional" status and said she was eligible to deduct the loss.

The Tax Court's evaluation of her argument illustrates how the courts look at the evidence of participation in an activity under the passive loss rules. Ms. Fenderson had to demonstrate that she spent at least 750 hours working on her properties and that she spent more time on them than she did for her regular job. She had no detailed time records for either job. The Court had no evidence as to the time spent on her Symantec job, so they assumed "without finding" that she was correct in saying she worked 15 hours a week there; since 15 hours x 52 weeks is 780, she would need at least that many real estate hours to qualify as a real estate pro.

To document her real estate time, Ms. Fenderson worked up a summary of hours based on her appointment calendar. The tax court found her summary wanting:

A number of inconsistencies between items shown on petitioner's 2002 return, her calendar, and the exhibits were brought out during petitioner's cross-examination at trial. Furthermore, upon careful review of those documents, we are unable to reconcile estimates of time shown on Exhibits 3-J and 4-P with entries made in petitioner's calendar. On many dates, the estimate of time spent on a particular activity exceeds the amount of time shown on that calendar for that date.

The court adjusted down her time based on the inconsistencies they found in the calendar, and decided she could only document 759 real estate hours - 21 hours less than her Symantec time.

The Moral? If you say you have a $180,000 part-time job, the tax law is likely to look pretty hard at your claims that you work more than that on your side job.

Cite: Fenderson v. Commissioner; T.C. Summ. Op. 2007-191

MATERIAL PARTICIPATION BASICS

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."

Tags: material participation.passive losses.real estate professional.

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