Taxpayers who are considered real estate professionals and who materially participate in real property business may count real estate losses as ordinary losses, avoiding the annual limitation on claiming passive activity losses.
In a recent U.S. Tax Court case, Doris Simmons-Brown and Joe Brown, a married couple who reside in New York, deducted large rental real estate losses during the 2010 and 2011 tax years. They had $32,739 in losses for 2010 and $37,123 in losses for 2011.
The Browns had used the full amount of these losses on their returns to offset other sources of income. They treated the losses as ordinary losses versus passive losses. There is a $25,000 limitation on the amount of passive activity losses a taxpayer can claim as a tax deduction in any one year.
The IRS subsequently audited years 2010 and 2011 and issued the Browns a notice of deficiency in the amounts of $11,983 for 2010 and $9,227 for 2011.
In 2010, the taxpayers had an additional issue in that they forgot to pick up some unemployment income, which is taxable. This issue was not litigated because both the taxpayers and the IRS agreed that this was additional taxable income.
Rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates. However, there is an exception to this rule if the taxpayer is considered to be a real estate professional.
A taxpayer meets the requirements to be treated as a real estate professional if:
1. 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
2. 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.
In the case of a joint return, these requirements are met if either spouse separately satisfies them.
Doris Brown kept a contemporaneous activity log in the form of a spreadsheet, which detailed the amount of time that Joe Brown spent working on the rental property. In addition, it was determined that Joe Brown spent an average of 15 hours per week working at a small construction contracting business that he owned.
The Tax Court reviewed Doris Brown’s spreadsheet and determined that it indeed qualified as a contemporaneous activity log. The court made some adjustments to her calculations and came up with the conclusion that Joe Brown had spent 1,008 hours performing services with respect to the rental activity for 2010. The court did a similar analysis for 2011 and determined that Joe Brown had spent a total of 752 hours of rental activity service.
He spent an average of 780 hours per year performing services for his construction contracting business for both 2010 and 2011. All of his activities for both years were spent in real property trades or business. The activities for the rental property and the construction contracting business are considered to be real property trades or businesses. Therefore, the Browns were treated as real estate professionals for both years at issue.
The rules to qualify for material participation are much easier to meet than the rules to qualify as a real estate professional. To meet the material participation rules, either spouse must provide 500 hours of services to the real estate activity.
Joe Brown performed 1,008 hours of services in 2010 and 752 hours of service in 2011. Therefore, he meets the material participation rules as well.
The Browns won the major issue against the Tax Court regarding the material participation rules. The amount of the deficiency judgment for 2010 was greatly decreased, and the deficiency for 2011 was waived in its entirety (Doris Simmons Brown and Joe Brown v. Commissioner, U.S. Tax Court, T.C. Summary Opinion 2015-62, Oct. 15, 2015).