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Rental activity losses and the rule of "material participation"

Last week we discussed the tax court case of one California couple that was audited for deducting losses for their rental properties. Rental activity is typically considered a "passive activity" under the tax code and is therefore subjected to a limit. California taxpayers with rental properties can avoid this limit on losses if they qualify as "real estate professionals" that materially participated in the rental of a given property. We discussed particular requirements of the "real estate professional test" in last week's post.

In the case of the California couple, the tax court noted that the husband qualified as a real estate professional because he completed many construction projects and performed additional real estate-related tasks such as renting the units, collecting rents, and performing maintenance work.

The next question that the tax court addressed is whether the husband "materially participated" in the rental activities. In this test the tax court considered the contributions of both the husband and wife and asked whether the couple's joint efforts amounted to material participation in connection with each rental unit.

There were two factors that the court considered in this test:

  • Whether the couple's efforts constituted substantially all of the participation (or work) done in the rental activity for the tax years in question, or,
  • Whether the couple spent more than 100 hours during the years in question engaged in real estate activities and whether this participation was more than that of any other individual.

The tax court found that the couple did not meet their burden of proof to avoid the passive activity loss limit on some rental properties, but that the couple did materially participate in renting other properties.

Most importantly, the tax court found that the taxpayers' extensive records and contemporaneous timesheets demonstrated that they acted in good faith, and therefore penalties were not warranted against the couple.

Source: United States Tax Court, "Tom and Nancy Miller v. IRS," T.C. Memo. 2011-219

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