Qualifying as a real estate professional can be the difference between being able to deduct losses from your real estate activities and having passive activity losses that you cannot deduct. For a Florida stockbroker with real estate losses of $307,933 in 2010, qualifying as a real estate professional was definitely worth the fight.
Windham vs. Commissioner
Patricia S. Windham, a long-standing stockbroker, worked for a few hours a day with Wells Fargo and spent the remainder of her time managing 12 properties that she owned. During the 2008 recession, Windham considered foreclosing on some of her rental properties but instead chose to withdraw $182,025 from her retirement account to cover her mortgage payments.
She reported a $307,933 real estate loss on her 2010 tax return and used it to offset her Wells Fargo income. The IRS sent her a notice of deficiency, stating that her losses were passive and therefore could not be used to offset her wage income. Windham filed a petition with the U.S. Tax Court.
In Tax Court, the IRS apparently argued that Windham was not a real estate professional and that she did not materially participate in her real estate activities.
The material participation test
First, since Windham failed to make the election to aggregate her multiple rental real estate activities together by filing a statement with her original income tax return for the taxable year 26 CFR 1.469-9 (g)(3), the court had to analyze whether she met the “material participation test” for each piece of real estate separately. See 26 U.S. Code § 469(c)(7)(A), 26 CFR 1.469-9 (e)(1).
Next, the court noted that under 26 CFR 1.469-5T, there are seven tests that can be used to prove that a taxpayer materially participated in an activity for the taxable year, and that three of them applied to the current case:
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(a)(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(a)(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year; [or]
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(a)(7) Based on all the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
To demonstrate “material participation,” Windham provided the court with a detailed account of the hours she worked at each of her properties. She provided evidence that she managed all of her real estate activities by herself – from collecting rent, to meeting prospective buyers, to overseeing repairs, to handling problems with utility and service companies. The court accepted Windham’s account of the hours she worked with her rental real estate and found that for 11 out of her 12 properties, Windham met at least one of the tests for material participation.
Note that Windham did not meet the material participation test for her 12th property (50% interest in a vacant lot), on which she spent only 12 hours in 2010.
Real estate professional test
Windham also met the test to qualify as a real estate professional in that (1) per 26 U.S. Code §469(c)(7)(B)(ii), she spent more than 750 hours (889.25 hours) during the tax year materially participating in her rental real estate activities, and (2) per 26 U.S. Code §469(c)(7)(B)(i) she spent more hours in her real estate activities than she did in her other work as a stockbroker (577.5 hours).
The Tax Court held that Windham was therefore entitled to claim her rental real estate losses in 2010.
If she had lost the case, she would have owed the IRS an additional $124,591!
Lessons from Windham
The Windham case proved to be a great success for the taxpayer, and holds some valuable lessons for real estate investors planning to qualify as real estate professionals:
- Although Windham was able to prove that she met the material participation test for 11 out of her 12 properties, most investors of multiple pieces of real estate will not. Therefore, be sure to make a Section 469 election to treat all of your real estate properties as one activity.
- As we have noted in many of our blogs on qualifying as a real estate professional, you must be able to provide complete and accurate records of your time spent during the tax year on your real estate activities. The courts will not accept “ballpark guestimates” particularly those made after receipt of a Notice of Deficiency!