- Posted on: Jun 12 2019
Mr. Cruz is an Attorney and Counsellor at Dunlap Bennett & Ludwig and concentrates on Estate Planning and Taxation
[06.12.19 Tysons] One of the most litigated issues in tax law is the losses of so-called “real estate professionals”. This is so because, generally, rental activities are passive activities even if the taxpayer materially participated in them. However, rental real estate activities in which taxpayer materially participated as a real estate professional are not passive activities. The distinction is crucial because passive losses can only be deducted against passive income, whereas non-passive losses can be deducted against non-passive income.
The rules are deceptively simple but they give rise to litigation because inevitably in real life the facts to which the rules are applied are complicated. Section 469(c)(7) states “taxpayers in real property business” need to meet the following two requirements: first, more than half of the personal services performed in all trades or businesses during the tax year were performed in real property businesses in which taxpayer materially participated; second, taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which taxpayer materially participated.
Nevertheless, the taxpayer may not count personal services performed as an employee in real property trades or businesses unless the taxpayer was a 5% owner of the taxpayer’s employer. The taxpayer is a 5% owner if he or she owned 5% of the employer’s outstanding stock, outstanding voting stock, or capital or profits interest. There is a long list of material participation tests. The most relevant ones for purposes of this article are if taxpayer participated in the activity more than 500 hours or if based on all the facts and circumstances taxpayer participated in the activity on a regular, continuous, and substantial basis, but for at least 100 hours per year. Finally, real estate professionals who have more than one rental real estate interest may choose to treat all of the interests as one activity.
A case decided by the Federal district court for the Western District of Arkansas illustrates the complexities of these provisions. Stanley v. U.S., Case No. 5:14-CV-05236, November 12, 2015. The case was before the court on cross-motions for summary judgment, which was granted to the taxpayer and denied to the government. Taxpayer Stanley filed the complaint seeking a refund of money paid to the Internal Revenue Service (IRS) with respect to his 2009 and 2010 returns. He paid $70,000 in additional taxes for 2009, $52,000 for 2010, both under protest, filed claims for refunds, and sued.
From 1978 to 1994 Stanley practiced law in Springdale, Arkansas, primarily representing real estate clients and financial institutions. In 1994 he began working full time as President of LMC, a property-management company in Fayetteville. By 2009 and 2010 he worked there half-time. Between 1994 and 2009 he was also the general counsel. He retired at the end of 2010. Starting in 1996 he was also President of LCI, a company which provided telecommunications services to certain properties managed by LMC.
From the beginning of his employment with LMC, the taxpayer acquired minority ownership interests in business entities which owned or operated rental properties and the adjoining golf courses managed by LMC. By 2009 and 2010 Stanley had ownership interests in more than 100 entities. He also owned directly two rental properties, 2% of another rental property, and interests in more than 88 entities through the Roy E. Stanley Family Limited Partnership.
For 2009 and 2010 taxpayer reported all income and losses from these interests as non-passive on Schedule E. When the Service audited taxpayer’s returns for those two years, it reclassified all of the Schedule E income and losses as passive, resulting in additional tax since he was unable to use passive losses to offset non-passive income.
Taxpayer argued the IRS erred in regrouping his Schedule E activities and reclassifying non-passive activity as passive; that he was “taxpayer in real property business” as he met the requirements of Section 469(c)(7); that his rental real estate activities and business activities could be grouped together as they formed an appropriate economic unit, because the business activities were insubstantial in relation to the rental activities and each owner of the business activities had the same proportionate interest in the rental activities; that the activities were non-passive as he materially participated in the grouped “Activity”.
The Service argued taxpayer was not a 5% owner of LMC, did not qualify as a real estate professional, did not appropriately group activities on Schedule E, and did not materially participate in an appropriately grouped activity. Under the above facts and arguments the court framed the issues before it as follows: whether Stanley was more than a 5% owner of LMC; whether he was a qualifying taxpayer under Section 469(c)(7); whether he appropriately aggregated his rental activities, and whether he appropriately grouped his rental and non-rental activities; and, whether he materially participated in the grouped activities. The court found for the taxpayer and against the Service on all four issues.
Posted in: Real Estate