Stay-Home Spouse Can Help Overcome Passive Treatment of Rental Activity Investments

Although side businesses like owning rental property can be dangerous because of the Section 469 passive investment limits, the tax code makes a nice exception if at least one person in the union (same-sex couples qualify after U.S. v. Windsor), is a real estate professional.  Gibson v. IRS summarizes the legal mechanics well:

“Taxpayers are allowed deductions for certain business and investment expenses under sections 162 and 212. Section 469, however, generally limits deductions from any passive activity loss. A passive activity loss is defined as the excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year. Sec. 469(d)(1). A passive activity is any trade or business in which the taxpayer does not materially participate. Sec. 469(c)(1). For the purposes of section 469 and to the extent provided in regulations, a trade or business includes any activity with respect to which expenses are allowable as a deduction under section 212. Sec. 469(c)(6)(B). Rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates. Sec. 469(c)(2), (4). Material participation is defined as involvement in the operations of the activity that is regular, continuous, and substantial. Sec. 469(h)(1).

“An exception to the rule that a rental activity is per se passive is found in section 469(c)(7), which provides that the rental activities of certain taxpayers in real property trades or businesses (sometimes referred to as real estate professionals) are not per se passive activities under section 469(c)(2) but are treated as a trade or business subject to the material participation requirements of section 469(c)(1). See sec. 1.469-9(e)(1), Income Tax Regs. A taxpayer may qualify as a real estate professional if: (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates and (2) 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. Sec. 469(c)(7)(B)(i) and (ii). In the case of a joint tax return, either spouse must satisfy both requirements. Sec. 469(c)(7)(B). Thus, if either spouse qualifies as a real estate professional, the rental activities of
the real estate professional are not per se passive under section 469(c)(2).”

So if the stay-home spouse can manage to spend fifteen hours a week actively participating (and keeping good records of it) in rental real estate activities and he or she does over half the total work on the properties, then any losses therefrom may be able to offset the other spouse’s W-2 income.

Made possible by the E.F.M. Law Company

Deducting Investment Losses from W-2 Income Requires Active Participation in the Investment

I work out!

It is relatively common for Americans with day jobs to engage in side activities for profit.  This might include owning rental properties, owning small family businesses, or investing in the businesses of others.  Congress and the IRS certainly support and would like to encourage such activity, but they must also be concerned with loopholes in the tax system.  Consequently, taxpayers are prohibited from creating passive investment losses to offset their W-2 income.  IRC Sec. 469.  For example, a doctor in the highest tax bracket (currently 39.6%) cannot invest her money in an outlet mall that is losing money to reduce her income below $400,000 a year – the 35% tax bracket.  The doctor would only be able to take those deductions if she actively participated in the operations of that outlet mall.

Lamas v. IRS is a recent example of successfully proving such active participation under this section of the code.  There, Mr. and Mrs. Lamas owned a collection of companies in the lumber wholesaling and construction industries in Florida.  Ownership was also sprinkled among their children, with whom Mr. Lamas participated with and helped make successful.  The Lamases had very good years between 2006 and 20087for which they were audited and assessed nearly $5 million in tax underpayments.  In short, the Lamas’ tax strategy was to carry back some losses in 2008 to their 2006 and 2007 taxes in order to offset some of that income and reduce tax.

The IRS relied on these Section 469 passive investment loss limitations to argue that Mr. Lamas did not materially participate in the various business ventures for which losses were offsetting some of his income from active activities.  In arriving at its ultimate decision – that the Lamases materially participated and were entitled to their deductions, the Tax Court explained:

“Generally, taxpayers materially participate if they are involved in the operations of the trade or business on a regular, continuous, and substantial basis. The regulations provide seven tests to determine whether a taxpayer materially participated, and a taxpayer only needs to satisfy one of those tests.  We find that Mr. Lamas satisfies at least two of these seven tests. Under one of those tests, taxpayers can satisfy the material participation requirement if they participate in the trade or business activity for more than 500 hours during the taxable year. Under the other, taxpayers can satisfy the material participation requirement if “[t]he activity is a significant participation activity * * * for the taxable year, and the * * * [taxpayers’] aggregate participation in all significant participation activities during such year exceeds 500 hours.”

The Tax Court held: “Mr. Lamas participated in work customarily done by owners, and he did not do this work with a purpose of avoiding the section 469 loss limitations. Mr. Lamas worked restoring Shoma [one of his company’s] assets and opportunities and finding potential investors for Shoma projects. In contrast to the example in the regulations, these activities are customarily done by owners. Further, Mr. Lamas’ purpose was to protect his investment in Shoma by helping Shoma to survive. Accordingly, the avoidance exception does not apply.”

Some slightly confusing aggregation rules also applied in this case (he worked at two related businesses), but ultimately the taxpayers (Lamases) prevailed here.  In short, material participation in one’s investment activities is necessary to offset active income by means of deductions on one’s annual 1040.

Lamas v. IRS, T.C. Memo 2015-59 (Mar. 25, 2015).

Passive Investment Losses Have Limits

Adeyemo v. IRS, T.C. Memo. 2014-1 (Jan. 2, 2014).

The first case of 2014, Adeyemo v. IRS, was a good reminder that “Rental activity (including rental real-estate activity) is per se passive unless the taxpayer qualifies as a real-estate professional as defined in section 469(c)(7)(B).”  Id. at p. 13.  For those of you who moonlight as landlords (less than 750 hours a year), be careful when claiming more deductions than earnings for your realty business activities–your passive activity losses can only be deducted to the extent of your passive activity gains.  Generally, IRC Sec. 469.

Reblogged from the E.F.M. Law Company, P.C.