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California couple takes IRS to court over passive activity losses

When the IRS fails to reasonably negotiate with a taxpayer, an experienced California tax litigation attorney should be prepared to take a client's case to court. Depending on the issues involved in a tax case, a case will be directed to the United States Tax Court, United States District Court, or the United States Court of Claims. Although going to court is not the first option for many taxpayers, sometimes going to tax court is the only way to aggressively challenge an unfavorable audit.

One of the most recent tax court cases involves a California couple that was audited by the IRS based on their rental real estate losses. The IRS contended that the couple's losses were "passive activity losses" and therefore subject to a limitation. Passive activity losses are an issue that many California residents run into. Although the rules regarding passive activities were first enacted to prevent the use of abuse tax shelters, the IRS has applied these rules to every business and rental activity that even the most modest-income taxpayers may participate in.

The IRS defines passive activities as "any rental activity OR any business in which the taxpayer does not materially participate. Non-passive activities are businesses in which the taxpayer works on a regular, continuous, and substantial basis. In addition, passive income does not include salaries, portfolio, or investment income."

In the case of the California couple who took the IRS to court, the couple contended that they materially participated in the rental of six of their rental properties and that the IRS was therefore wrong to characterize the losses from those properties as passive activity losses.

We will discuss further issues in this case in our next post.

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

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