Ships Pilot / Developer Case Shows Importance of Aggregation Election

Originally Published on forbes.com on September 18th,2011

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I first started trying to read, look at really, “everything” in a desire to come up with little practical tips for my firms client base.  The case of Tom Miller ( TC Memo 2011-219) brings me back to my roots.  Mr. Miller piloted large ships in San Francisco bay.  As I understand it when a big ship gets close to a harbor the conning gets turned over to someone local who is very familiar with the currents and sand bars and the like.  As a member of the San Francisco Bar Pilots Association, Mr. Miller was on seven days and off seven days at a stretch.  Even when he was on, it was fairly predictable as to when he was needed.  Bottom line, even though his main job was one with enormous responsibility and requiring great skill and training, it left him with quite a bit of free time to pursue other activities.

Mr. Miller chose real estate and being something of a workaholic he put  a lot of time into it.  His wife complained about having to go to construction sites, if she wanted to see him during the day.  Whatever the effect all that time had on his home situation, it was good for his tax situation.  That is because of the way the passive  activity loss rules  (Section 469) work.  The rules require us to separate our income producing activities into buckets.  If all the activities in the passive bucket net to a loss, that loss is suspended and carried forward.  A portion of the carried forward loss will be identified with each of the activities and released if that particular activity is disposed of.  Otherwise the loss just sits there until the passive bucket is profitable overall.  The details of it get rather complex so the Tax Reform Act of 1986, which created this system,cannot exactly be viewed as a simplification for a lot of people.

One of the rules of 469 is that rental activities are per se passive regardless of how much time you spend on them.  This worked a hardship on the real estate community, which is on the influential side, so a modification was made to the effect that for someone engaged in a real estate trade or business, the per se passive rule did not apply.  The problem with things like this is definitions.  In order to qualify as being in a real estate trade or business you need to annually spend 750 hours at it AND spend more time at the real estate trade than any other trade.  Now, whenever I read a case, I have a rule that I will root for one side or the other.  Because of my professional predisposition, I will usually root for the taxpayer, unless the taxpayer is being really lame.  The rules around the real estate trade or business exception to the per se passive rule produce an excessive amount of lameness among taxpayers.

Now you are never going to get ahead as a small time landlord without a good bit of do-it-yourself.  It’s not surprising that this carries over into doing your own tax return.  Representing yourself on audit and then going into Tax Court pro se might be overdoing it.  (It is understandalbe though given the dollars involved).  ConsiderYusufu Y. Anyika.  He knew about the 750 hours and might have been aware that the biggest problem people have is documenting the time they spend, so he was careful to provide good time records for the 800 hours he spent on his properties (Nice 50 hour cushion there).  All that work just got him slapped around by the Tax Court, becasue he didn’t fully understand the rule:

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 therental 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.

 Mr. Miller was anything but lame:

In addition to Mr. Bogart, other witnesses described Mr. Miller’s work ethic as extraordinary. A friend, pilot and partner of Mr. Miller’s at SFBPA testified to his “one in a million” work ethic, saying that he did not know anyone who worked harder.

Probably more important was the peculiar schedule of the piloting job and the fact that he engaged in other real estate actiivity, besides managing his own property.  The Court had no problem recognizing Mr. Miller as a real estate professional:

Respondent [IRS] highlights that Mr. Miller was a partner in the SFBPA. Respondent also notes that Mr. Miller occasionally spent additional time on SFBPA-related activities outside of piloting. Nevertheless, we find petitioners’ testimony and evidence compelling. Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B).

That’s not the end of the story, though.  Mr. Miller had six rental properties.  The Tax Court found that he materially participated in two of them, but not the other four.  The 750 hours only gets you out of the per se passive rule for rental.  Each activity still has to be evaluated for material participation.  The gold standard for material participation is 500 hours, which would be challenging for even someone with as strong a work ethic as Mr. Miller.  There are, however, other ways to meet the standard including 100 hours and more time than anybody else spends.  Mr. Miller met that standard on two of the properties.

It would seem that the real estate professional exception would be of little interest to owners of multiple properties if they have to establish material participation in each of them.  Actually, they don’t.  They can elect to aggregate their properties.  This is where Mr. Miller, who had the good sense to not go pro se into Tax Court, was tripped up by “do it yourself”:

Mrs. Miller prepared petitioners’ joint returns for the years at issue. Petitioners did not make an election to treat all their interests in rental real estate as one activity under section 469(c)(7)(A) before or during the years at issue.

Frankly, it would be a better world if it was organized so that people like the Millers could safely do their own tax returns.  I might have to switch to smiling and saying hello to people as they came into Walmart, but it would be worth it.  Nonetheless that is not how the world is organized.  It is what it is.  Deal with it.  The Millers return with the real estate activities was like a larger ship rather than a speed boat.  It needed a pilot to bring it into the harbor. The need for the aggregation election is something that would have been picked up by a someone who focused on returns.If you are reading this and saying – Oh __________ – you should be aware that the IRS is pretty generous in allowing late elections to aggergate. PLR 20117011 which I mentioned back in June is an example of a late election being allowed.