One of the most common questions I answer is how to be classified as a real estate professional for tax purposes. Being classified as a real estate professional enables the taxpayer to the treat a rental loss as non-passive, which offers tax advantages. So if you have a rental property are you considered someone who materially participates as a real estate professional in the management of that property?
The recent case of Hairston v. Commissioner (TC Memo 2019-104), gives an interesting analysis and explains the IRS’s stance on this question.
The husband and wife taxpayers purchased two single family homes adjacent to their primary residence. Each rental home sat on a 1.5 acre lot with a 50 foot driveway and one of the rental homes had a six car garage. Both properties had tenants under long-term lease agreements. The tenants agreed to pay monthly rent in cash or by check, to pay utility charges, and to perform minor house repairs. The tenants also agreed to maintain the yard and surrounding area by removing yard waste and keeping the paths to the driveways free of snow and debris. The six car garage was reserved primarily for the taxpayers, who used it to park their vehicles and for storage.
Both taxpayers performed tasks in connection with the rental activity. Mrs. Hairston, who worked full time for the Department of Homeland Security, handled most financial and administrative tasks, such as keeping books and depositing rent checks. She also performed most tasks related to securing new tenants, including market research, advertising, reviewing rental applications, and preparing leases. She generally met prospective tenants who came to view the properties during the evening or on weekends.
During the tax year in question Mr. Hairston supervised contractors who replaced carpet and painted the interior of a property while it was temporarily vacant. In each case he met the contractors at the house and (according to his testimony) remained onsite until they finished their work. But he did not participate in any of this work himself.
The IRS disallowed the entire rental loss (deemed it a suspended passive loss) and challenged the taxpayer’s assertion of real estate professional status. However, they accepted the real estate activity aggregation election filed by the taxpayer.
Deductions are a matter of legislative grace, and taxpayers generally bear the burden of proving their entitlement to all deductions claimed. Taxpayers bear the burden of substantiating their claimed deductions by keeping and producing records sufficient to enable the IRS to determine the correct tax liability.
The Hours Test
To qualify as a real estate professional, a taxpayer generally must “perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.” Sec. 469(c)(7)(B)(ii). For taxpayers filing a joint return, at least one spouse must independently satisfy the 750-hour requirement. The hours test applies to each activity separately unless an election to aggregate the real estate activities into one activity is made on the taxpayer’s return (the taxpayer properly filed this election).
In the absence of “contemporaneous daily time reports, logs, or similar documents,” the extent of participation may be established by “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”
In the case of the Hairstons, the taxpayers produced a calendar for each rental property that purports to show the number of hours worked each day. Together the calendars include 360 separate entries. Each entry describes a task and the hours allegedly consumed in performing that task, without indicating which taxpayer did the work. The handwriting on all entries seems identical. Some of these entries were recorded on the day of performance, but most were made at the end of the week or later. The taxpayers at trial identified who performed certain tasks (e.g., mowing grass and removing snow). But many entries are ambiguous in this respect.
The court had trouble believing the taxpayer estimates for time spent. “We find the hours recorded on the calendars to lack credibility for several reasons: Every task recorded on the calendars, no matter how trivial, is listed as having taken at least one hour to complete. Of the 360 recorded entries, 121 (or roughly one-third) record tasks that allegedly consumed exactly one hour. These include 36 entries for doing nothing more than receiving a rent payment, issuing a receipt for a payment, or depositing a check at the bank. There are 13 distinct one-hour entries for “paying mortgage.” There are 11 distinct one-hour entries—all of which petitioners attribute to Mr. Hairston—for “hunting down” or “reminding” the tenant to pay rent. Three of these entries appear in the same week, including two on the same day. There are nine distinct one-hour entries for “inspecting vacant property,” i.e., walking next door to make sure it had not been broken into. An inflationary pattern also emerges from the calendar entries recording time that Mr. Hairston allegedly spent supervising contractors. He recorded many hours during which he allegedly watched contractors work, including 33 hours while they installed and cleaned carpet. During one week in December, he recorded another 40 hours “supervising” contractors who were painting the interior of a property. We understand that Mr. Hairston, having recently retired, had time on his hands. But we cannot believe that he spent an entire week watching paint dry. This pattern of inflating recorded hours undermines the credibility of petitioners’ calendars overall.”
Most taxpayers with a few rental properties will find it difficult to achieve real estate professional status, especially if the taxpayer is also receiving a W-2 from a fulltime job. Regardless, the IRS and courts have made it clear that detailed service records need to be maintained and must be credible.
About the Author
Bryce Nations, CPA, CFP is a Tax Partner in the Real Estate practice of Frazier & Deeter, one of the largest and fastest growing accounting and advisory firms in the U.S. His clients include some of the country’s largest real estate and timber investment companies. He specializes in dealing with high net-worth individuals, flow through entity structures, foreign institutional investors and closely held businesses.