In what has happened quite often over the past few years, the Tax Court found in the case of Hairston v. Commissioner, TC Memo 2019-104[1] that the taxpayers had failed to show that either was a real estate professional. Thus, losses of just under $55,000 over three years were treated as passive activity losses.

IRC §469(c)(2) provides a blanket rule that a rental activity is automatically treated as a passive activity. However, IRC §469(c)(7) was added to the law to grant relief from this automatic treatment to individuals who are real estate professionals.

To be a real estate professional, a taxpayer must meet the following two tests under IRC §469(c)(7)(B):

More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.[2]

Married couples are not allowed to meet these tests by combining their hours, even if they file a joint return. Rather, at least one of the spouses must meet these tests individually.[3]

Most often, the problems arise when the taxpayers are asked to show documentation that these requirements are met—and this case is no different.

The Court summarized the requirements the taxpayers must meet to adequately document their hours to qualify as a real estate professional:

A taxpayer may substantiate the required 750 hours of participation by any reasonable means, but a “ballpark guesstimate” will not suffice. Moss, 135 T.C. at 369. In the absence of “[c]ontemporaneous daily time reports, logs, or similar documents,” the extent of participation may be established by “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).[4]

The taxpayers had a calendar for each of their two rental properties that claimed to show the number of hours worked each day on the rental properties, with a total of 360 entries on the two calendars. The calendars indicate what was done and time claimed to be spent but did not indicate which spouse undertook each activity. The court noted that the handwriting appeared identical on each of the calendars and that while some entries were recorded on the date the work was performed, most were recorded at the end of the week in question or even later.[5]

The calendars showed a total of 932 hours of work that was claimed to have been performed, but it was not clear which spouse performed which services. Ultimately the parties disagreed on how the hours should be divided—the IRS found that 170 hours were performed by the wife, 669 hours by the husband and that 93 hours were unclear. If all of the uncertain hours were assigned to Mr. Hairston (who was retired and thus would likely meet the second test), that put him barely over the required hours of 762.[6]

The taxpayers took a different view of the hours, but in the end, they were asserting that 782 hours were performed by Mr. Hairston.[7] So in either event, if Mr. Hairston’s hours were even slightly inflated on the calendars, the test would not be passed.

Unfortunately for the taxpayers, the Tax Court found a number of reasons to doubt that the hours in the calendar accurately reflected the hours of activity performed by Mr. Hairston even if the taxpayer’s 781 hours of activities were accepted as tasks performed by Mr. Hairston. Some of the problems included:

Every task, no matter how trivial, was shown as taking at least one hour to perform. 36 of these one-hour activities consisted of receiving a rent payment, issuing a receipt for a rent payment or depositing the check at the bank. Similarly, there 13 entries for one hour for paying the mortgage and 11 one hour tasks for reminding tenants to pay the rent.[8]
Between 93 and 105 hours was related to snow removal for 2014. Nothing in the terms of the leases indicated that the landlord was responsible for such snow removal. As well, one-third of hours were listed as preparing for a single snowstorm and “deciding” related to this snowstorm. At trial, it was discovered this snow removal related to a garage the tenants had no right to use—the taxpayers stored vehicles and tools in that garage.[9]
Additional hours consisted of time that Mr. Hairston reportedly was simply “watching” contractors. He spent 33 hours watching carpet being installed and cleaned, and other 40 supervising contractors painting the inside of one rental. The Court found that even though Mr. Hairston, being retired, had “time on his hands,” it wasn’t credible to believe he spent “an entire week watching paint dry.” Even if he had been there, the Court found that the hours did not count as participation—at best he was “on-call” to answer questions, and on-call time does not count towards participation. [10]

The Court determined that Mr. Hairston’s hours were inflated by a minimum of 150 hours—and regardless of which total hours number the Court decided to accept (the IRS’s or the taxpayers’), once 150 hours were deducted Mr. Hairston no longer met the 750-hour minimum to be a real estate professional.

Taxpayers need to understand the detailed requirements for such records, and the need to pass a “smell” test for the hours they claim to taken to accomplish certain tasks. While the adviser does not have to check into the taxpayers’ records in detail before preparing a return claiming real estate professional status, the preparer must clearly communicate the type of records that will need to be available to sustain the position on examination.

A failure to properly document that the client was informed of these requirements can come back to haunt the preparer should the taxpayer be upset at the end of the exam and look to file a civil complaint for damages (likely any penalties and return/exam professional fees) and/or a complaint with the state board of accountancy.

[1] https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12024, August 20, 2019, retrieved August 24, 2019

[2] IRC §469(c)(7)(B)

[3] IRC §469(c)(7)(B)

[4] https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12024, August 20, 2019, retrieved August 24, 2019, p. 8

[5] Ibid, p. 8

[6] Ibid, p. 9

[7] Ibid

[8] Ibid, pp. 9-10

[9] Ibdi, pp. 10-11

[10] Ibid, p. 11