Case — Rental Real Estate Losses

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TL Case Summ

THE QUESTION

Do hours worked in a real estate office qualify a taxpayer for an exception to the rules that limit rental property losses?

THE DISPUTE

Taxpayer Says: She was engaged in a real property business and losses on her rentals are currently deductible in full.

Internal Revenue Service Says: The losses are not currently deductible because the taxpayer did not meet the requirements of the “real property business” exception to the passive activity rules.

THE LAW

From Internal Revenue Code Section 469(a): Generally, the deduction of passive activity losses is suspended.

From Internal Revenue Code Section 469(c)(2), (4): A rental real estate activity is generally treated as a passive activity without regard to whether the taxpayer materially participates in the activity.

From Internal Revenue Code Section 469(c)(7)(A): In establishing whether a taxpayer’s real property activities result in passive activity losses, each interest of the taxpayer in multiple rental properties is treated as a separate rental real estate activity, unless the qualifying taxpayer makes an election to treat all interests in the rental properties as a single rental real estate activity.

From Internal Revenue Code Section 469(c)(7)(B): Provides an exception to the general rules suspending the deduction of passive activity losses when a taxpayer materially participates in a real property trade or business.

From Internal Revenue Code Section 469(c)(7)(D)(ii): Services performed as an employee do not count toward the time requirements of meeting the real estate professional exception to the passive rules unless the employee is at least a 5% owner.

THE CAUSE OF THE DISPUTE

Losses on rental properties that you own are “passive activities.” Passive activity rules limit the losses you can claim on your current year tax return to the amount of your passive income unless 1) you sell the property, 2) you qualify for a special allowance that allows you to deduct up to $25,000 of your losses, or 3) you are a real estate professional.

When you’re a real estate professional, you can treat your rental losses the way any other business would–that is, you can deduct the losses in full in the current year.

To qualify as a real estate professional, you have to participate in your real estate activities on a regular, continuous and substantial basis, as well as spending more than 50% of your time and more than 750 hours working on the activities during the year. Services you perform as an employee do not count unless you’re at least a 5% owner of the real property business. In addition, for the loss to be deductible, you have to materially participate in each rental activity unless you choose to group them into one activity for tax purposes.

In this case, the taxpayer worked as an employee at an incorporated real estate brokerage business more than 750 hours per year (she was a licensed real estate agent assistant). Per her employment agreement, she was entitled to receive 6% of the brokerage’s net profits as compensation.

The taxpayer and her husband also owned three rental properties. They spent less than 750 hours managing the properties during each of the years in question (2006 and 2007), and did not elect to treat the three properties as one activity on their tax returns.

The taxpayer believes she qualifies for the “real estate professional” exception to the passive activity rules. Due to the employment agreement, she owned more than a 5% profit interest in the brokerage, so she believes her time spent as an employee there means she was engaged in the real property business, and those hours count toward meeting the time requirements of the real estate professional exception.

She deducted the losses in full on her tax returns ($39,154 for 2006 and $12,195 for 2007).

The IRS says the hours worked at the real estate brokerage don’t count because the taxpayer was not a stockholding owner of the business, which was a corporation. Therefore, she fails the “greater than 750 hours test” and does not qualify for the exception, so the losses are not currently deductible.

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, 17KB)

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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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Sorry, wrong answer :(
Right answer!
For the IRS. The taxpayer was an employee, not an owner, of the brokerage because the business was a corporation and she did not own stock. She did not qualify for the exception to the passive activity loss rules for taxpayers in a real property business as provided in section 469(c)(7). The taxpayer is not entitled to the disallowed passive activity deductions during the years at issue.
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