Passive Activity Loss Rules Lead To Yet Another Taxpayer Loss In Court – Why Keeping Adequate Records Is Essential
Passive Activity Loss Rules Lead To Yet Another Taxpayer Loss In Court – Why Keeping Adequate Records Is Essential
In a recently issued Memorandum Opinion[1], the United States Tax Court found that a husband and wife who owned and operated real estate investment properties were not entitled to deduct losses derived from properties owned in their individual capacity, flow-through losses from prior years because they were engaged in a passive activity, and depreciation on the wife’s personal vehicle. The court additionally found the couple was liable for accuracy related penalties for 2013 and 2014, the years in question. This case turns primarily on the passive activity loss rules provided in § 469, a topic we have previously discussed in depth, including this excellent article by Charles J. Allen.[2]
Facts
The petitioners formed Magnet Development, LLC (“Magnet”) in Georgia in 2007 to manage their real estate investments. Husband and wife each owned 50% of Magnet, a non-TEFRA partnership for federal income tax purposes. Magnet purchased a 21-unit apartment building approximately 150 miles away from the petitioners’ home. The petitioners also purchased property in two other cities. The couple owned these two properties in their individual names, not by way of their interest in Magnet.
Both husband and wife had full-time jobs as computer specialists during the years in question. The couple presented to the court that they also worked as full-time real estate professionals. To support this claim, they had two separate logs in which they cataloged the work spent on the respective properties. One log provided a basic description of the work done, with no mention of the time spent working, while the other log provided the date, name of property, time worked, and a brief description of the activity performed.
In 2013 and 2014, Magnet, owned in equal parts by the husband and wife, reported net losses. Notably, it reported income and claimed deductions for the two properties individually owned by the couple, not Magnet. Magnet also claimed depreciation at 100% business use for a new vehicle purchased by the wife in 2013.
The couple filed a joint return for both years in issue, but they did not make an election to group their rental real estate activities as one activity for purposes of Section 469(c)(7)(A) for either year. They claimed flowthrough losses in 2013 and 2014 of $85,260 and $48,740, respectively. The IRS issued notice of deficiencies of $24,451 and $14,440 and accuracy-related penalties pursuant to Section 6662(a) of $4,890 and $2,880 for taxable years 2013 and 2014. The issues before the court included whether the couple was entitled to deduct (1) depreciation on petitioner wife’s automobile, (2) losses from the individually owned properties, (3) flowthrough losses from Magnet, and (4) whether the couple was liable for accuracy-related penalties.
Depreciation Deduction on Wife’s Vehicle
In 2013, the wife, not Magnet, purchased the vehicle. Nevertheless, Magnet claimed depreciation on the wife’s automobile for both years in issue. The Code allows a depreciation deduction for reasonable wear and tear for property used in a trade or business.[3] To be entitled a deduction, a taxpayer must establish the property’s depreciable basis by providing the cost of the property, its useful life, and previously taken depreciation.[4] Particular to vehicles, a taxpayer must show the vehicle was at least partially used in a trade or business, and any deduction is allowable only to the extent it was actually used in the trade or business. In the present case, the court found that the couple failed to show the cost of the vehicle, when it was placed in service, the amount it was used in the real estate business, and any previous deduction they had taken, and therefore sustained the disallowance of a deduction for the years in issue.
Losses from Individually Owned Property
The two properties the couple owned individually, not through Magnet, produced losses of $3,662 and $5,100 in 2013 and 2014, respectively. Despite owning the properties outright, the couple claimed these losses on Magnet’s return. The couple provided zero evidence or reason as to why Magnet should be entitled to deduct these losses, and the court rightfully sustained the disallowance of Magnet taking these deductions. Additionally, the petitioners never claimed that they should be entitled to deduct directly on Schedule E of Form 1040. Even if they had, the court notes they would not have been entitled to them for the reasons provided below.
Flow-Through Losses from Magnet
Here, the couple failed at every step of the court’s analysis, including failing to substantiate their adjusted basis in Magnet, the amount they had at-risk in Magnet, and that their participation in Magnet was active rather than passive. A partner’s share of a partnership loss is only allowable to the extent of the partner’s adjusted basis in the partnership at the end of the year in which the loss occurred.[5] Because the couple failed to produce any evidence regarding the adjusted basis either of them had in the partnership in 2013 or 2014, the court ruled that they were not entitled to deduct any losses from Magnet in the years in issue. Despite this conclusively ending the issue as to whether the couple was entitled flow-through deductions, the court provided an additional analysis of the at risk and passive activity limitations.
Taxpayers are entitled to losses from rental real estate only to the extent to which the taxpayer is at risk for such activity at the end of the year.[6] At risk amounts include the amount of money and the adjusted basis of property contributed by the taxpayer to the activity and the borrowed funds for which the taxpayer is personally liable.[7] Here, the couple failed to produce any evidence indicating the amount at which they were at risk in respect of their real estate activities.
In conjunction with the at risk rules, taxpayers may only use losses derived from passive activity to offset any passive income. Any excess of passive losses over passive income may not be deducted, but instead carried forward to future years in which the taxpayer has passive income.[8] A passive activity is any trade or business in which the taxpayer does not materially participate[9], and rental activity is per se passive regardless of material participation.[10] There is an exception to this per se rule if the taxpayer is a real estate professional.[11] This is not to say, however, that activity by real estate professionals is automatically active income. Rather, if the taxpayer meets the requirements of a real estate professional, they still must pass the material participation tests provided in the regulations.[12]
In the present case, the couple failed to show that they met the requirements of real estate professionals or materially participated in the real estate activity. That is not to say, though, that they did not. The court’s analysis turned mainly on the utter lack of information and evidence provided by the couple. Taxpayers may establish hours of participation by any reasonable means,[13] and the court is not required to accept a “ballpark guesstimate” or the unverified, undocumented testimony of taxpayers.[14]
Here, while the couple provided the two logs of their activities to the court, the court found them wholly inadequate, stating that they were “vague and misleading” and did not specify who performed the work indicated and also noted the hours recorded were inflated. The couple also made no election in the years in issue to treat all of their rental real estate activities as one activity. Notices of deficiency are presumed correct, and the taxpayer bears the burden of proving otherwise.[15] The taxpayers’ lack of evidence in this case surely did not overcome this burden, and the court sustained all disallowances of deductions.
Accuracy-Related Penalties
Regarding the accuracy-related penalties imposed on the taxpayers, the court first opined on the procedural requirements the Commissioner must follow, which was of no issue in this case. The court then turned to the taxpayers’ actions. The penalty for an underpayment attributable to a substantial understatement of income tax will not apply to the extent the taxpayer shows he both had a reasonable cause and acted in good faith with respect to that portion of the underpayment.[16] Here again, the court held against the taxpayers, stating, “Petitioners have not presented any evidence that their underpayments were due to reasonable cause.”
Conclusion
This case, while not novel or groundbreaking, illustrates the importance of maintaining adequate documentation and records for all aspects of a business, particularly when taking an aggressive position on their tax return. Furthermore, proper planning and advisement could have avoided many of the issues entirely, such as the properties and vehicle that was owned by the couple individually, rather than by Magnet.
[1] Dunn v. Commissioner, TC Memo 2022-112.
[2] https://esapllc.com/sezonov-2022/
[3] U.S.C. § 167(a).
[4] Cluck v. Commissioner, 105 T.C. 324, 337 (1995).
[5] U.S.C. § 704(d).
[6] U.S.C. § 465(a).
[7] U.S.C. § 465(b).
[8] U.S.C. § 469(a).
[9] U.S.C. § 469(c)(1).
[10] U.S.C. § 469(c)(2).
[11] U.S.C. § 469(c)(7).
[12] Treas. Reg. § 1.469-5T(a).
[13] Id.
[14] Moss v. Commissioner, 135 T.C. 365, 369 (2010).
[15] Welch v. Helvering, 290 U.S. 111, 115 (1933).
[16] U.S.C. § 6664(c).
