The 2015 federal district court case in the Western District of Arkansas, Fayetteville Division, Stanley v. U.S., involved Carol A. and Roy E. Stanley. The case centers on whether the taxpayers qualified as real estate professionals, which would allow them to deduct rental losses from a rental activity in which they materially participate against ordinary income (i.e. wages, interest, etc.).
If a taxpayer is not considered a real estate professional, then those losses are considered passive and in most situations, not currently deductible against ordinary income.
The federal district court ruled in favor of the Stanleys. This ruling bodes well for taxpayers that own rental real estate activities while also working as a minority owner in a realty activity.
The definition of a “real estate professional” for tax purposes is different from the standard definition of this term. For tax purposes, it is a term used to define an individual who has rental properties and qualifies to treat them as a non-passive activity. There are a few requirements to be considered a real estate professional. You can reference another blog article I posted that delves into those requirements. For this article, generally speaking, to qualify as a real estate professional you must meet two requirements:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year must involve real property trades or businesses in which the taxpayer or the taxpayer’s spouse materially participates; and
- The taxpayer must perform more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer or the taxpayer’s spouse materially participates.
The personal services of the taxpayer as an employee in a real estate activity was the primary issue in Stanley v. U.S. Personal services performed by the taxpayer as an employee are not taken into account under either requirement listed above unless the employee owns more than a 5% interest in the employer (IRC 416(i)(1)(B)(i) defines a more than 5% owner). In the case, the taxpayer testified that from the time he began working for the company in 1994, he owned 10% of the company. The taxpayer did not make a capital contribution for the shares received. The shares were restricted based on his employment with the company.
In the case, the government took the position that the taxpayer was not more than a 5% owner of the company; therefore, he could not be a real estate professional since his hours as an employee in a real estate activity would not count towards real estate hours. The government argued that the restricted shares were not sufficient to substantiate the taxpayer’s alleged ownership.
The court ruled that the taxpayer had shown his ownership by a preponderance of evidence. The court further found that the stock did not need to be readily transferable or not at risk of forfeiture to allow the taxpayer to claim the 10% ownership. Thus, the court found the taxpayer to be a 10% owner of the company and he could count the real estate related hours worked in the company towards the real estate professional requirements listed above.
The court case gives credence to a taxpayer’s ability to include their hours under similar fact patterns. Although, it should be noted that this case represents one U.S. District Court case and a different court may come to a different conclusion with a similar fact pattern.
If you own and are involved in rental real estate properties, you should consult with your tax advisor to see if you qualify for the “real estate professional” status for tax purposes. The tax savings can be significant. However, the rules are complicated and the details of your specific situation should be reviewed with a qualified tax professional.
For more information, contact Anna Coldwell at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.