Tax Court Disallows Rental Loss Deduction to Taxpayer Who Failed to Qualify as a Real Estate Professional

In our last post, we explained how an architect proved to the Tax Court that he qualified as a real estate professional, and was subsequently permitted to deduct passive activity losses from his real estate activities. Here, we focus on the attempt of another person to do the same — and why and how he failed.

Penley vs. Commissioner of Internal Revenue
Zane W. Penley worked full-time as a sterilization technician and sales account representative for a company that develops biomedical and security systems for the healthcare and aviation industries. In 2012, he spent at least 2,194 hours working for that company. He also worked as a licensed Colorado real estate broker and conducted real estate activities through an S Corporation owned with his wife. Their corporation owned two single-family residential properties in Littleton, Colorado. Penley and his wife also had a warehouse in Sedalia, Colorado which they held in a self-directed IRA through a limited liability company.

On his 2012 tax return, their S Corporation reported a nonpassive ordinary business loss of $96,354, and no passive losses from real estate activities. Penley’s individual tax return reflected a $96,354 passthrough loss as a nonpassive loss. The IRS determined, however, that $56,863 of that loss consisted of passive losses from Penley’s real estate activities and that Penley did not qualify as a real estate professional under 26 U.S. Code § 469(c)(7). Since Penley’s adjusted gross income also exceeded the phaseout threshold for the Section 469(i) $25,000 passive activity loss deduction that year, the IRS disallowed his a passive real estate loss deduction in full. It also imposed 26 U.S. Code § 6662(a) accuracy-related penalties.

Penley fails to prove qualification as a real estate professional
To qualify as a real estate professional under Section 469(c)(7), a taxpayer must prove to the court that (1) More than half of their work during the taxable year was spent “materially participating” in a real property trade or business, and that (2) the material participation amounted to more than 750 hours of services during the taxable year. Taxpayers may use any reasonable means to prove services performed and time spent on their real estate activities, including submitting appointment books, calendars, and narrative summaries. Post-event “ballpark guesstimates,” however, may not be used.

The Tax Court acknowledged that Penley spent a significant amount of time and effort on his real estate activities in 2012, but did not find his testimony credible:

  • Penley claimed that he spent 2,520 hours on his rentals, including 1,000 hours on the rehabilitation of one of the properties – a rehabilitation that was still incomplete in 2015 (the property had never been occupied nor had it been offered for rent).
  • Adding 2,520 real estate hours to the documented 2,194 hours working full time for his company would have meant that Penley worked a total of 4,714 hours in 2012, or 12.88 hours per day for 366 days straight.
  • Penley’s primary piece of evidence at trial was his 2012 monthly calendar, which the court found had greatly exaggerated the time he spent on his real estate activities – the calendar contained brief descriptions of his work, an estimate of the number of hours he worked rounded to the nearest hour or half-hour, and the number of miles driven to and from the property.
  • His calendar entries marked neither a start nor an end time for his work, nor did they include time spent for meals and other breaks.
  • Although Penley submitted corroborating evidence in the form of emails, credit card statements and phone bills, he failed to reconcile this evidence with the large blocks of time shown on his calendar.

Can’t shift responsibility to tax preparer
The Penleys attempted to establish reasonable cause and good faith for the purpose of avoiding the 26 U.S. Code § 6662(a) accuracy-related penalties, by claiming that that they relied on the advice of their tax professional. The Tax Court denied this claim, ruling that since they provided their return preparer with a “liberal estimate” of their hours, they “cannot shift to their preparer responsibility for the returns that were prepared on the basis of that apparent exaggeration.”

The importance of keeping complete and accurate records
The IRS is actively challenging taxpayers who claim tax status as real estate professionals, and it is crucial that you keep complete and accurate records to successfully defend an audit. For tax advice, audit assistance, or tax litigation representation, contact the Real Estate Tax Group at Moskowitz, LLP today.

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