Court Agrees with IRS that Real Estate Professional’s Losses Were Considered Non-Deductible Passive Losses
A Tax Advantages of Being a Real Estate Professional Is that Rental Losses Are Not Treated as Passive Losses and Can Be Offset Against Ordinary Business Income
What Makes the Case of Greg & Juli Eger, U.S. District Court, N.D. California, 2019-2 U.S.T.C. ¶50,248, (Aug. 30, 2019) Unique?
As an affiliate member of the Suburban West Realtors® Association, we see various taxpayer arguments made by real estate investors in our Exton PA office to maximize tax deductions in an attempt to decrease tax liabilities. By sharing these taxpayer arguments, we hope other real estate investors better understand the thresholds that they must meet to protect their tax positions.
The taxpayers, Greg and Juli Eger, owned numerous rental properties, including the three at issue here. The taxpayers grouped these three properties along with their other rental properties as a single rental real estate activity.
Greg Eger met the requirements to claim status as a Real Estate Professional (“REP”). Thus, with respect to the passive activity rules where a taxpayer does not materially participate, the taxpayer’s status as a REP allows their rental activities not be considered passive. This would allow the taxpayer to deduct their non-passive losses against their non-passive income.
The three rental properties at issue were managed by management companies. The Egers paid the management companies a percentage of rent received in exchange for services the management companies provided.
IRS Finds Taxpayers Had No Rental Activity for the Three Properties at Issue
The IRS found that these 3 properties did not qualify as rental activities and that the taxpayers had accordingly artificially increased the total amount of business loss they sought to claim (as the losses from these three properties would be non-deductible passive losses).
The IRS regulation sets forth seven exceptions to the definition of rental activity. The parties agree that their dispute centers on one of the exceptions, which states that the activity is not rental activity if [t]he average period of customer use for such property is seven days or less. A period of customer use is further defined as [e]ach period during which a customer has a continuous or recurring right to use [the property]. The IRS contended that this exception applies to the three properties at issue because the average period of customer use for each of them was seven days or less. The taxpayer argued that it met the 7-day or more test.
Who Was the Renter (Customer) of the Three Properties?
The IRS found that the renters of these three properties stayed for an average period of use as the end-user guests for less than seven days. In fact, the taxpayers made no attempt to prove that its renters stayed for more than seven days. Instead, the taxpayer argued that the management companies, not the renters, satisfied the greater than seven days test.
The IRS cited the definition of rental activity as being any activity where payments are principally for the use of tangible property. Therefore, the payment is tied to the use of the property and in this case the renters, not management companies, were paying to use the properties. The IRS logically argued that the management companies acted as the taxpayer’s representatives, not customers of the properties.
The court ruled in favor of the IRS by finding that the property management companies did not have a continuous or recurring right to use the three properties because the taxpayers retained significant rights to use the properties throughout the tax years at issue. Moreover, the taxpayers provided no legal or factual support for their position that the management companies had a recurring right to use these properties.
Tax Planning Tip #1
Hogs get slaughtered. The taxpayers may have thought that their aggressive position would never be detected by the IRS. The taxpayers likely self-prepared their tax returns as no experienced tax professional would have taken the position that the property management company was the customer and not the renters. Really? They may have played the audit lottery game and lost.
Tax Planning Tip #2
The taxpayer, rather than agreeing to the IRS assessment, decided to bear the expense of going to court to contest the IRS position. While every taxpayer dreams of having his day in court to show that the IRS is wrong, the facts of this case did not support a challenge. The facts were clear that the renter was the user of the rental properties, not the management company.
Had the taxpayer consulted with an experienced tax professional when the return was prepared, the IRS audit examination of three years of tax returns would likely have been avoided, along with the cost of the audit and court costs.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander, an Enrolled Agent and a Certified Tax Resolution Specialist, is an affiliate member of the Suburban West Realtors® Association, a member of the American Society of Tax Problem Solvers (ASTPS), PA Society of Tax & Accounting Professionals (PSTAP), the National Society of Accountants (NSA) and the National Association of Tax Professionals (NATP). He is the author of “How to Resolve Your IRS Tax Debt Problems” as well as a book on how to start your own business. He has been practicing in Exton for 19 years. His firm serves clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
For individual tax payers, real estate professionals, contractors and other self-employed individuals with IRS tax debt issues or tax planning issues, feel free to contact me at (610) 594-2601 or by email at email@example.com.
Keystone Financial Solutions, Inc. specializes in providing innovative tax planning, tax preparation, and solving IRS tax debt problems. The company’s web site is https://www.keysolutions.us and its telephone number is (610) 594-2601.
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