Tax law allows real estate investors to write off part or all of their losses from rental activities if they meet certain conditions. However, as a new case shows, Foradis, TC Summ. Op. 2024-13, 07/11/24it is difficult to convince the tax court that you have invested the necessary time – especially if you have another full-time job.
background: Typically, investors in passive activities in which they are not “substantially involved,” such as most real estate activities, can only take deductions up to the amount of their passive income for the year. They therefore cannot claim passive annual losses (PALs), although limited depreciation is allowed for certain real estate investors. Under this exception, you can use up to $25,000 of loss to offset non-passive income if you meet the definition of an “active participant.” However, the $25,000 offset is phased out at modified adjusted gross income (MAGI) between $100,000 and $150,000.
On the other hand, if your real estate activities reach the rank of real estate professional, you can fully deduct losses from your non-passive income, just like any other business. There are three main requirements to be classified as a real estate professional.
1. You are “substantially involved” in real estate transactions or deals.
2. You spend more than 750 hours on your real estate business or business.
3. The hours spent on real estate transactions or deals are more than half of all the hours you spend on your overall business activities.
The third requirement is the one that tripped up the taxpayer in the new case.
Facts: A husband filing a joint tax return with his wife reported taxable wages of $161,000 in 2020, including $78,000 for himself. He also reported real estate rental activities from a carriage house they built in 2020. On their 2020 tax return, they claimed a net loss of more than $22,000 from the carriage house activities against their non-passive income.
First, the IRS said the couple was not eligible for the active participant partial offset because they exceeded the dollar threshold. So they tried the second approach: The couple claimed the husband qualified as a real estate professional.
In 2020, the husband worked full-time, 40 hours per week, and took two weeks off for personal time. Accordingly, to prove that he spent more than half of his time on real estate activities, he would have to prove that he spent more than 2,000 hours on real estate activities.
The husband claimed that he actually worked 2,500 hours in 2020 on construction and other work related to the carriage house – well over the threshold. He said he did this work after his regular job, on weekends, and during the two-week vacation. He provided logs and receipts to support his position and relied heavily on his own testimony. But the tax court didn’t believe him.
Diploma: The tax judge calculated that the husband would have had to work 40 hours a week at his regular job and 48 hours a week in the real estate business. That left only about 80 hours a week for sleeping, eating, cleaning, bathing, sleeping, commuting, and all other facets of human life – an average of about three hours a day after sleeping. That struck the judge as “implausible.”
Result: The husband did not have the necessary qualifications as a real estate professional.
