Material Participation Must Always Be Documented

The IRS frequently argues that losses are limited by the passive activity loss rules. This often turns on whether the taxpayer materially participated in the business or rental activity. The Hailstock v. Commissioner case shows that the IRS expects taxpayers to document their participation even when it seems clear that the tests are met.

The Facts & Procedural History

The facts and procedural history in Halistock are as follows.

The taxpayer left her full-time job in 2004 to learn about the business of acquiring, rehabilitating, renting, and selling properties. The taxpayer started by taking real estate classes.

During the next four years the taxpayer purchased numerous properties. She used an inheritance, savings, two lines of credit, and credit cards to make the purchases.

She rented and incurred expenses in relation to some of the properties; she sold some of the properties within one year of acquisition (without renting); and she held some of the properties for investment (without renting).

The court noted that she “spent well over 40 hours per week carrying on her real estate business.” The court also noted that this involved:

  • checking messages for work orders,
  • purchasing materials and cleaning supplies,
  • supervising workers doing rehabilitation work,
  • meeting with and conducting background checks on prospective tenants,
  • executing leases,
  • handling complaints regarding existing tenants,
  • searching for new properties to purchase,
  • taking real estate classes, and
  • collecting rent payments from tenants.

The IRS audited the taxpayer’s tax returns for tax years 2005 through 2009. It made several adjustments. This included adjustments based on the taxpayer’s real estate losses being non-deductible passive activity losses. The IRS took this position despite the fact that it seemed clear that the taxpayer materially participated in her rentals.

The Court’s Conclusion

The court considered whether the taxpayer satisfied the 750-hour requirement to be a real estate professional.

The real estate professional rules provide exception to the passive activity loss rules. When the requirements are met, the real estate professionals rental losses are not deemed to be passive. The taxpayer still has to satisfy the material participation rules.

As noted by the court, only hours for activities that the taxpayer materially participated in count in determining whether the 750-hour requirement is met.

There are several tests that establish material participation. One tests asks whether the taxpayer spent more than 100 hours in the activity.

The taxpayer has the burden of showing that these requirements are requirement. This involves a facts and circumstances analysis.

Absent an election to group individual rental properties together, the 100 hour test is applied and analyzed on a property-by-property basis. The taxpayer did not make a grouping election. Thus, the IRS argued that the taxpayer could not show that she materially participated in each individual property.

The court had this to say about the taxpayer’s activities and her participation:

Petitioner satisfies the facts and circumstances test …. because of her credible testimony and the substantial amount of money and time devoted to each rental property. Petitioner testified credibly and in detail about her duties in operating her real estate rental business. We find petitioner’s narrative summary convincing because she owned numerous rental properties and conducted her business as a one-man operation without being otherwise employed. As previously discussed, petitioner spent well in excess of 40 hours each week doing work related to numerous rental properties (i.e., researching prospective properties, maintaining properties, supervising work orders, finding tenants, securing leases, and continuing education related to rental real estate). The record before the Court indicates that petitioner received sizable amounts of rental income during the taxable years in issue and used substantial amounts of her own resources to facilitate the rental operation.

So the court had no problem determining that the taxpayer materially participated in each rental property. This seems self-evident from the facts, which the court all but admitted.

The Take Aways

The takeaway is that the IRS expects real estate investors to document their time. Absent a grouping election, for real estate activities, the IRS expects to document their time on a property-by-property basis. This case further establishes that narrative summaries and support gathered on audit or later can help establish that the losses are deductible.

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