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Rental real estate: those don't also serve who only stand and wait

September 21, 2010

The tax law "passive loss" rules limit "passive loss" deductions to the amount of "passive" income earned in a tax year, except when a "passive activity" is disposed of in a taxable sale. A special rule makes it worse for owners of rental real estate, which is always "passive" unless you qualify as a "real estate professional." If you do qualify, then you can avoid the passive loss limits if you "materially participate" in the activity -- a test based on how much time you spend on the activity.

The tax law says you have to meet two requirements to be a real estate pro:

- You have to spend at least 750 hours working in real estate trades or businesses, and
- You have to spend more time working in real estate than on any other activities.

A nuclear plant operator in New Jersey operated several rental properties on the side. The properties showed a loss on his joint 2007 return of $40,490, which he deducted in full as a real estate professional. The IRS looked at the return and disallowed the deduction attributable to his being a real estate professional (part of the loss was allowed anyway under a provision that allows some taxpayers with incomes under $150,000 to deduct part of a passive real estate loss) and asserted negligence penalties.

The taxpayer, a Mr. Moss, could only come up with 645.5 hours of work spent on the properties in 2007. But he could have worked more because he was "on call" in case something went wrong, as the Tax Court explained:

Essentially, petitioners claim that Mr. Moss could have been called to perform work at the rental properties at any time that he was not working at the Hope Creek plant, and, therefore, such on call hours should count toward meeting the 750-hour service performance requirement. We do not agree with petitioners' contention that Mr. Moss' "on call" hours may be used to satisfy the 750-hour service performance requirement. Section 469(c)(7) applies where the taxpayer "performs more than 750 hours of services". Sec. 469(c)(7)(B)(ii) (emphasis added); see also sec. 1.469-9(b)(4), Income Tax Regs. ("Personal services means any work performed by an individual in connection with a trade or business" (emphasis added)). While Mr. Moss was "on call" for the rental properties, he could have been called in to perform services; however, these services were never actually performed by him. Accordingly, we conclude that Mr. Moss' time "on call" for the rental properties does not satisfy any part of the 750-hour service performance requirement.

The court upheld the disallowance and the penalties.

The Moral? Coulda, woulda doesn't get you far in Tax Court.

Cite: Moss, 135 T.C. No. 18

Below: material participation basics.

The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "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.

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