Originally published on Passive Activities and Other Oxymorons on May 27th, 2011.
Yusufu Y. Anyika, et ux. v. Commissioner, TC Memo 2011-69
After the introduction of the at-risk rules, real estate was the last real tax shelter. Then came the passive activity loss rules. The passive activity loss rules (Code Section 469) require us to put our trade our business activities (including interest in flow through entities) into buckets. Losses in the passive bucket can only be used to the extent of gains in the passive bucket (It is not an "offset". Passive capital gains release passive ordinary losses. So sometimes a gain can reduce your liability.) Losses that are not used are carried forward and are attached to the activity that generated them. They are released when the activity is fully disposed of even if there is no passive income in that year.
Activities are classed as passive based on how much you participate in them. Their are a number of ways to meet the "material participation" standard. The simplest is 500 hours per year. "Rental activities" are special. They are deemed to be passive regardless of how much time you spend on them. There is an exception to that rule. Rental losses are not "per se" passive to people engaged in real estate trade or businesses. The magic number here is 750 hours:
such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Sometimes people miss that "materially participates" part of the requirement. In order for the exception to work for many people, they need to make an election to aggregate all their real estate activities for purposes of measuring material participation. Otherwise somebody with five properties might not be considered to be materially participating in any of them.
Now the 750 hours is not the whole story as Mr. Anyika discovered a bit late in the game. Here is his situation:
Petitioners, Yusufu Yerodin Anyika (Mr. Anyika) and Cecelia Francis-Anyika (Mrs. Francis-Anyika), are married and filed joint returns for tax years 2005 and 2006. Mr. Anyika is employed as an engineer, and he works 37.5 hours per week, 48 weeks per year. Mrs. Francis-Anyika is employed as a nurse, and she works 24 hours per week.
Mr. Anyika has been purchasing, renovating, managing, and selling rental properties since the 1990s. He views his rental real estate activity as a second job and as an investment. During 2005 and 2006, Mr. Anyika owned two rental properties.
Mr. Anyika spent a good bit of time on the properties and thought he should qualify for the real estate trade or business exception. He explained this in his petition and at trial:
In their petition and at trial, petitioners contended that Mr. Anyika qualified as a real estate professional because he had spent at least 750 hours actively managing the rental properties. On Form 4564, Information Document Request, submitted by petitioners during their audit, petitioners declared, under penalty of perjury, that Mr. Anyika devoted 800 hours per year to working on the rental properties during 2005 and 2006.
With that nice fifty hour cushion he thought he was all set. Unfortunately 750 hours is not the only requirement. Here is the other requirement:
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
Mr. Anyika also worked full time as an engineer which took up substantially more than 800 hours per year. He tried to salvage the situation:
It was only after the Court had explained the law that Mr. Anyika understood, for the first time, that he would have to have spent at least 1,800 hours engaged in the real estate business in order to qualify as a real estate professional under section 469(c)(7)(B). After understanding that, to qualify, he had to spend more hours engaged in managing the rental properties than he did working as an engineer, Mr. Anyika began to contend that he had spent the equivalent of 8 hours per day, 5 days per week, 48 weeks per year (1,920 hours per year) working on the rental properties. After being confronted during trial by the evidence of his prior signed statement that he worked 800 hours per year on the rental properties, Mr. Anyika stated that he was “speaking from memory with the exact numbers”, and that to be sure, he would need to look over the numbers more closely.
The Court did not find him credible:
We do not find Mr. Anyika's testimony that he worked approximately 1,920 hours per year on the rental properties credible. Not only does it contradict his earlier signed statement, but it also changed during trial once Mr. Anyika realized that he would need to have devoted more hours to his real estate properties than to his job as an engineer (i.e., he would need to have spent more than 1,800 hours working on the rental properties), instead of the 750 hours he had originally believed would be sufficient for him to qualify as a real estate professional under section 469(c)(7).
When it came to the penalties taxpayers tried the classic "Turbo Tax made me do it" defense. The Court, using more measured if less colorful language, gave the old data processing answer to the Turbo Tax defense - Garbage in, Garbage Out. Their has been much talk, of late, of what the qualifications of people who prepare tax returns should be. Their will be special exams with members of some professions such as CPA's exempt from taking then. Based mainly on reading tax court decisions, I think members of some professions should be required to take a special exam before they are allowed to prepare their own returns specifically engineers and attorneys. Nobody ever listens to me, though.