Case — Counting the Hours in Rental Real Estate Losses

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TL Case Summ

THE QUESTION

Do hours spent “on call” count when determining whether real estate losses can be currently deducted?

THE DISPUTE

Taxpayer Says: In addition to time spent actually working on his rental properties, he spent additional time “on call” and ready to perform work. These hours count toward meeting the requirement that allows losses from the rental properties to be fully deducted on his current return.

Internal Revenue Service Says: The “on call” hours do not count because the taxpayer was not performing personal services for the rental properties during those times. The rental loss is not fully deductible in the current tax year.

THE LAW

From Internal Revenue Code Section 469: Generally disallows any passive activity loss for the tax year. A passive activity is any trade or business in which the taxpayer does not materially participate.

From Internal Revenue Code Section 469(c)(2): A rental activity is generally treated as a passive activity regardless of whether the taxpayer materially participates.

From Internal Revenue Code Section 469(c)(7)(B): A taxpayer qualifies as a real estate professional and is not engaged in a passive activity under section 469(c)(2) if: (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates [750-hour service performance requirement].

From Federal Tax Regulation 1.469-9(b)(4): Personal services means any work performed by an individual in connection with a trade or business.

THE CAUSE OF THE DISPUTE

Taxation of real estate rentals is governed by the passive loss rules of the Internal Revenue Code, which limit deductions and other tax benefits related to your rental properties. That means if you have a loss on a rental property, you may not be able to deduct the entire loss on your income tax return in a particular year.

Two exceptions to the general rule exist. One is when you “actively participate” in the rental activity, you may be able to deduct up to $25,000 of the losses (limited by your adjusted gross income). Under another special rule, when you “materially participate” in your rental and meet certain eligibility requirements, you can be considered a real estate professional. In that situation, your losses are treated as business losses, and are not limited by the passive activity rules.

In this case, the taxpayer had a full time job and owned four rental properties. In 2007, when he was not at his full time job, he spent 645-1/2 hours performing maintenance and other services on his rentals. In addition, he was “on call”, and ready to perform any necessary work on the rentals when he was not at his full time job. He believes these “on call” hours count toward the 750-hour service performance requirement that would allow his rental losses to be deducted in full on his 2007 tax return.

The IRS says that while the taxpayer could have been called on to perform work, he was not actually performing work on the rentals while “on call” and those hours do not count. The losses are not fully deductible in 2007.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 20KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. Time “on call” for the rental properties does not satisfy any part of the 750-hour service performance requirement. Taxpayer’s rental real estate activities must therefore be treated as a passive activity under section 469(c)(2). (Editorial note: The taxpayer’s adjusted gross income of $131,656 also limited the amount he could deduct under the $25,000 rule.)
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