Vandegrift v. Commissioner, TC Memo 2012-14 (January 12, 2012)
Jon and Kate may have had eight, but another Pennsylvania couple, Ray and Kathleen, had nine. In fact, not only did Ray and Kathleen Vandegrift have nine children, they also had nine rental properties, providing Ray with a convenient excuse to keep himself busy outside of the home while Kathleen chased after the brood.
In addition to his job selling cleaning products, Ray claims to have spent more than 750 hours, and more than half of his professional time, on activities related to the couple’s rental properties. If this were the case, Ray would qualify as a “real estate professional” and the passive activity loss limitations noted in CPA exam review would not apply to the $25,000 in losses generated by the rental properties.1
Unfortunately, between the sales job, his rental activities, and dealing with a wife who was left with nine kids all day, Ray had no time to document what, exactly, he was doing. Although the Tax Court found Ray to be “honest and forthright,” his subjective estimates of time, unsupported by any contemporaneous documentation, were not enough to convince the court that he qualified as a real estate professional and thus the losses from the rental properties could not offset the couple’s other income.
Section 469(a)(1)(A) generally prohibits a taxpayer from recognizing a loss from passive activities. As crucially explained in study for CPA exam preparation, passive activities include any rental activity2 except as provided in Code §469(c)(7). That section specifies that taxpayers who: (1) perform more than one-half of their personal services in real property trades or businesses in which they materially participate and (2) perform more than 750 hours of services in real property trades or businesses in which they materially participate are not subject to the passive activity loss limitation with respect to their real estate rental activities. A taxpayer who meets these requirements is commonly referred to as a “real estate professional.” This is the key exception to passive loss limitation described in CPA review materials.
Taxpayers do not have to prove with mathematical certainty that they meet these personal service requirements to achieve real estate professional status; contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. For example, the taxpayer may be able to establish the types of services performed and the approximate number of hours spent performing such services based on appointment books, calendars, or narrative summaries.3 However, the evidence presented must be more than merely a “ballpark guestimate” of the time devoted to the requisite activities.4
The Tax Court has rejected the proposition that the amount of time a taxpayer was “on call” to perform work with regard to his rental properties should be counted toward his service hours.5 In another case, although the taxpayer had a contemporaneous daily calendar showing the number of visits she made to her rental properties, the court rejected the taxpayer’s estimate of hours that she assigned to these activities years later in preparation for trial.6 Some of the factors influencing the court were the seemingly excessive estimates of time for the tasks identified, the fact that many of the taxpayer’s trips to the rental properties were combined with other activities, and that the taxpayer had hired a property manager for one of her rental properties.7 Any of these factors may appear on a sample CPA test to illustrate the careful assessments required for determining if someone is a real estate professional.
Although the court did not think it was proper to impose the negligence penalty with regard to this issue in Vandegrift because of the taxpayer’s reliance on his tax preparer and the “technical nature” of the issue, preparers should be cautious about advising their clients with regard to the passive activity loss limitations in situations like this. At the very least clients should be advised of the requirements discussed above and the types of documentary support that the IRS and the courts will expect in support of the taxpayer’s position regarding real estate professional status. Under Circular 230, a practitioner may rely on information furnished by the client without independently verifying that information. However, ethics training following CPA exam study points out that a practitioner may not ignore the implications of information he or she is aware of and must make reasonable inquiries if the information as furnished by the taxpayer appears to be incorrect, inconsistent, or incomplete.8
1 Since Ray had earned $120,000 as a salesman, the so-called “small landlord” exception from the passive activity loss limitation was essentially phased-out.
2 IRC §469(c)(2).
3 Temp. Reg. §1.469-5T(f)(4).
4 Goshorn v. Commissioner, T.C. Memo. 1993-578.
5 Moss v. Commissioner, 135 T.C. 365 (2010).
6 Bailey v. Commissioner, T.C. Memo. 2001-296.
8 Circular 230 §10.34(d).
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.