Qualifying for the real estate professional exception to the PAL rules
Most property owners know that the passive activity loss (PAL) rules can prevent a taxpayer from claiming passive losses from real estate if the taxpayer’s only other income is nonpassive (such as salary from a job). Exceptions exist, though, including the real estate professional exception. A recent case, Hickam v. Commissioner, addresses whether a mortgage broker/lender could take advantage of the exception. It provides a useful refresher on what it takes to qualify as a real estate pro.
Rental real estate activities are generally considered passive, so rental losses can usually offset only passive income. The Internal Revenue Code, however, grants an exception for certain taxpayers who materially participate in the activity and are real estate professionals. To qualify as a real estate professional, you must perform:
- More than 50% of your “personal services” in real property trades or businesses, and
- More than 750 hours of services in real property trades or businesses.
If you meet these requirements, you can deduct your rental losses even if you don’t have passive income.
Why were the taxpayer’s deductions rejected?
In Hickam, the taxpayer was an independent contractor who brokered real estate mortgages and other loans in 2011. In 2012, he also worked for an employer, originating loans secured by real estate. As a side job, the taxpayer managed and maintained three rental real estate properties.
The taxpayer claimed combined rental losses of $47,730 for 2011 and $48,945 for 2012. After an audit, the IRS rejected these deductions.
The Tax Court ruled in favor of the IRS. It found that the taxpayer had failed to prove the amount of time he’d spent on mortgage brokerage and loan origination services, as required for the first test. He also couldn’t show that he’d performed more than 750 hours in real property trades or businesses in which he’d materially participated for 2011 or 2012.
Notably, the court held that the taxpayer’s mortgage and loan services didn’t constitute a “real estate trade or business,” because they related to residential and commercial loans — not to the operation and brokerage of real property. So, the court faulted the taxpayer because it wanted substantiation for the amount of time he’d spent on non-real estate trades or businesses in order to determine if the percentage of time he’d spent on rental real estate personal services was greater than 50% of his total personal services. In other words, the court was concerned about the first test to qualify, not the second one.
The taxpayer here didn’t begin to reconstruct his hours of service on the mortgage/lending activities and rental property activities until after the audit. His re-created documentation for 2011 and 2012 allegedly was based on leases, bank statements, checkbooks, bills and receipts. But he didn’t present any of this corroborating evidence at trial. Not surprisingly, the court found the “vague, nondescriptive entries and ballpark estimates of time” unreliable and disallowed the rental real estate loss deductions.
If your rental losses are challenged, you’ll need to be able to establish your hours of participation. Contemporaneous records aren’t required, but you should at least have appointment books, calendars or narrative summaries that identify the services performed and the approximate amount of hours for each.