In the case of Rogerson v. Commissioner, TC Memo 2022-49[1] the taxpayer argued that, following a reorganization of the S corporation he owned 100% of into multiple corporations, he had not materially participated in the activities of one of these resulting corporations for the three years following the reorganization. He took this position despite not separating this particular activity from other activities of the prior corporation in earlier years, treating the operations of that S corporation as a single activity in which he actively participated.

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.

The IRS argued that the taxpayer in Barbara v. Commissioner, TC Memo 2019-50 did not materially participate in the trade or business of lending money, leading to a proposed assessment of tax of over $536,000 along with a 20% substantial underpayment penalty under §6662(a).  But the Tax Court did not agree with the IRS’s view in this case.

After selling his trucking business, Fred Barbara used the money to start a money lending business.  The office of the money lending business was in Chicago, IL.  The business employed two full time employees:  an accountant and a secretary.

When taxpayers attempt to reconstruct their hours in activities from memory when they receive an exam notice to sustain their burden of proving qualification as a real estate professional, the result is rarely a successful defense of that assertion.  Many of the problems are illustrated in the case of Pourmirzaie v. Commissioner, TC Memo 2018-26.

The taxpayers did have several rental properties.  The Court listed them as follows:

• A four-unit residential property in San Jose, California (San Jose property);
• A single-family condominium in San Diego, California, in which petitioners owned a partial interest (San Diego property);
• A single-family residence in Tucson, Arizona (Tucson property);
• A single-family condominium in Bremerton, Washington (Bremerton property); and
• A single-family residence in Discovery Bay, California (Discovery Bay property).

The taxpayers did not maintain any sort of log or calendar of the work performed on these properties during the years in question.  Nevertheless, on their tax returns for the year in question they took the position that Mrs. Pourmirzaie was a real estate professional. 

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His tenants’ inability to deal with taking out the trash appears to have been a key factor in allowing the taxpayer in Franco v. Commissioner, TC Summary Opinion 2018-9 to qualify as a real estate professional.

Jose Franco is a licensed architect and he ran a small architectural business for the year in question.  Normally this would create a significant issue for Mr. Franco to be classified as a real estate professional, since Mr. Franco was not contending that his architectural work was a real property trade or business. 

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In a case discussed here in 2015 (Restricted Stock Interest Still Found to Constitute Ownership Interest for Qualifying as Real Estate Professional) an Arkansas U.S. District Court held that a taxpayer who held restricted stock that constituted greater than 5% of the stock of the corporation could count hours worked in that entity towards qualifying as a real estate professional.

As is discussed in the original article, so long as no Section 83(b) election is filed by the taxpayer, the restricted stock is treated for S corporation purposes as "not issued" and thus does not create second class of stock issues.  The IRS had argued that same provision meant that the stock had to be ignored for purposes of the 5% stock ownership rule for counting as real estate professional hours time spent working as an employee for the S corporation.  The court did not agree with the IRS and treated the individual as a real estate professional.

Now the IRS has announced the agency will not follow the result in this case in Action on Decision 2017-07.  In a footnote the agency described the specific issues the agency was disagreeing with.

Nonacquiescence relating to the holdings that: 1) mere possession of a stock certificate, disregarding other conditions, restrictions or limitations on the possessor’s rights regarding the stock, constitutes ownership for purposes of § 469(c)(7)(D)(ii); and 2) work performed by the taxpayer in a rental real estate activity for purposes of § 469(c)(7)(A) may also constitute work performed by the taxpayer in non-rental business activities of the taxpayer for other purposes of § 469.

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While it is not impossible to qualify as a real estate professional under IRC §469(c)(7) if the taxpayer has a non-real estate full time job, it certainly is going to be difficult.  The limited number of hours in the year created a credibility problem for the taxpayer in Penley v. Commissioner, TC Memo 2017‑65, causing the Tax Court to find he had proven he qualified as a real estate professional.

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A Technical Advice Memorandum issued by the IRS after the audit ended was cited by the Tax Court to the IRS’s detriment in the case of Hardy v. Commissioner, TC Memo 2017-16. The issue involved was whether a surgeon materially participated in a surgical center in which he owned a minority interest—with the IRS at court pushing for finding that the surgeon had to combine that activity with his regular medical practice for purpose of determining material participation.

The surgeon this case is a plastic surgeon, specializing in pediatric reconstructive surgery, who operated on patients in his office and in some local hospitals.  The surgery must take place outside of his office if the surgery requires general anesthesia.  The doctor was finding that at times he was having difficulty obtaining space at the local hospitals for his procedures due to a limited number of available operating rooms.

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How activities are grouped can have a major impact on a taxpayer’s ultimate tax liability under the passive activity regulations provided under IRC §469.  Generally, a proper grouping is governed by Reg. §1.469-4(c)(2).

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Delores Gragg in 2006 and 2007 was a licensed real estate agent who had sufficient hours in the real estate activity to be treated as a real estate professional under IRC §469(c)(7).  Based on that qualification alone, she and her husband took the position that she should be allowed to be treated as materially participating in the rentals and thus all losses be allowed in full on their returns without regard to Section 469.

However the Ninth Circuit Court of Appeals, considering this “automatic material participation” argument for the first time, rejected this view in the case of Gragg v. United States, Case No. 14-16053, CA9 affirming a decision of the U.S. District Court of Northern California.

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A recent Arkansas U.S. District Court case involved the court resolving a number of not often raised in court questions regarding the interaction of the passive activity rules, the real estate professional classification, S corporations and stock provided to an employee that was subject to restrictions triggering treatment under IRC §83(b).  The case in question is the case of Stanley v. United States, 116 AFTR2d ¶2015-5419, Case No. 5:14-CV-05236, U.S.D.C. Western District of Arkansas.

The issues arose regarding Mr. and Mrs. Stanley's claimed deductions for losses on Schedule E that arose from real estate related activities.  Mr. Stanley took the position that he qualified as a real estate professional and that all of the various items reported on Schedule E were properly classified as a single activity under the passive activity rules.

In the case of Kline v. Commissioner, TC Memo 2015-144 the question before the Tax Court was whether the taxpayers in this case met the requirements to be treated as materially participating in the activity.

Specifically the question was whether they had met the requirements of Reg. §1.469‑5T(a)(3) for the “more than others” test for material participation. 

The taxpayer in the case of Padilla v. Commissioner, TC Summary Opinion 2015-38 did not fall into the traps that have caused other taxpayers to lose their cases claiming to be a real estate professional and deducting losses arising from their rentals.  But he found himself trapped by a different problem.

The IRS has lost again on the question of material participation for a taxpayer helping the family business deal with the financial crisis of 2008.  In the case of Lamas v. Commissioner, TC Memo 2015-59, the issue was whether the taxpayer had materially participated in businesses in 2008 where the taxpayer’s share of losses generated multi-million refunds from a net operating loss carryback.

In order to qualify for “real estate professional” status for the taxpayer’s rental properties, the taxpayer must meet certain participation requirements in a real estate trade or business.

A taxpayer was able to persuade the Tax Court, if not the IRS, that he was a real estate professional who materially participated in the rental of a triplex next door to his home in the case of Smith v. Commissioner, T.C. Summary Opinion 2014-112.