The passive activity loss rules are often a major roadblock for taxpayers involved in rental activities. One recent case, Stanley v. U.S. (W.D. Ark. 2015), however, demonstrates how work done as an employee can help qualify a taxpayer for the benefits of the real estate professional exception.
Rental real estate activities are generally considered passive, so rental losses can offset only passive income. Internal Revenue Code Section 469, however, grants an exception for a taxpayer who is a real estate professional and materially participates in the activity. To qualify as a real estate professional, you must satisfy these two requirements: 1) More than 50% of the “personal services” you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services in real property trades or businesses in which you materially participate.
Personal services performed as an employee can count as real property trade or business hours only if the employee owns more than 5% of the employer. This hurdle often trips up taxpayers who own a portion of a project and receive a salary from an employer in which he or she is not an owner.
The taxpayer in this case worked full-time for Lindsey Management Co., Inc., (LMC) as its president for 15 years. He later went to half-time status before retiring. From the beginning of his employment with LMC, he acquired minority ownership interests in more than 100 entities that owned or operated rental properties and adjoining golf courses managed by the company.
On his 2009 and 2010 tax returns, the taxpayer reported all income and losses resulting from his ownership interests as nonpassive. The IRS reclassified the income and losses as passive, however, which caused the taxpayer to owe additional taxes because he could not use the losses to offset nonpassive income.
In court, the taxpayer argued that he was a real estate professional. However, the IRS asserted that his hours worked as an LMC employee should not be treated as having been performed in a real property trade or business, because he did not own more than 5% of the company.
The court, however, ruled that the taxpayer owned 10% of LMC from the time he began working there, as evidenced by a stock certificate. It dismissed the IRS’s argument that the taxpayer did not own stock because he did not make a capital contribution for his shares, noting that capital contribution is only one avenue of acquiring ownership.
The IRS may very well challenge your use of rental losses in order to offset nonpassive income. If you want to take advantage of the real estate professional exception to withstand such challenge, take the time to carefully track your hours spent on rental and other real estate activities, whether as an employee or not.
Qualifying for the real estate professional exception is very specific to individual facts and circumstances.
If you have questions, or would like to review your situation, please contact Anita Wescott at [email protected], or call her at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.