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Passive activities and the "real estate professional" test under the tax code

In our last post we discussed the importance of hiring an experienced California tax litigation attorney when the IRS refuses to reasonably handle the negotiations surrounding an unfavorable audit. We also discussed a recent tax court case in which California taxpayers challenged the IRS' characterization of their rental losses as "passive activity losses" that were subject to certain limitations.

The couple claimed that they were actively involved in the rental of their properties because they took the following steps:

  • Spent great amounts of time researching and bidding on various rental properties.
  • Placed Craigslist ads with pictures for the rental units.
  • Prepared written leases for the rental properties.
  • Collected the rents.
  • Created contemporaneous spreadsheets showing the amount of time spent on real estate activities.
  • Performed maintenance on the properties including yard work and repairs of doors, wells, and septic systems, among other things.

Rental activity is generally treated as a passive activity under the tax code unless a taxpayer can show that he or she is a real estate professional and satisfies certain rules for material participation. There is a two-part test that a taxpayer must meet to qualify as a real estate professional under the tax code:

  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. Such taxpayer performs more than 750 hours of service during the taxable year in real property trades or businesses in which the taxpayer materially participates.

We will discuss how the court applied this test to the taxpayers in our next post.

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

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