Determining Material Participation: Tax Court Addresses Property Owners "On-Call" Hours

You likely know that “real estate professionals” enjoy some tax benefits that aren’t available to other taxpayers, but it’s not as simple as merely giving yourself the label. You must meet strict rules to qualify. For example, you must perform more than 750 hours of real estate–related services. But does being “on- call” qualify for hours worked? Rules on Passive Activity Losses The Internal Revenue Code (IRC) generally prohibits taxpayers from deducting passive activity losses except to the extent that they have passive activity income. Taxpayers can carryforward any excess passive loss to offset passive income in future years or deduct the losses carried forward when the property is disposed of. A “passive activity” is defined as any trade or business in which the taxpayer doesn’t “materially participate” — that is, participate on a regular, continuous and substantial basis. A passive activity loss is the excess of the taxpayer’s aggregate losses from all passive activities for the year over the aggregate income from all passive activities. Rental real estate activities are usually deemed to be passive regardless of whether the taxpayer materially participates; however, the IRC grants an exception to this rule for real estate professionals. For real estate professionals, rental activities are treated as an ordinary trade or business activity and any losses from the rental activity can be deducted against non- passive income. A taxpayer qualifies as a real estate professional by satisfying two requirements:

  1. More than 50% of the personal services the taxpayer performs in trades or businesses must be performed in real property trades or businesses in which he or she materially participates and
  2. The taxpayer must perform more than 750 hours of services in real property trades or businesses in which he or she materially participates.

When taxpayers file a joint tax return, the requirements are satisfied only if one of the spouses separately meets the two requirements. According to federal tax regulations, a taxpayer can establish the extent of its participation “by any reasonable means.” “Reasonable means” include identification of the services performed during a time period and the approximate number of hours spent performing those services during the period based on appointment books, calendars or narrative summaries. The Tax Court Case In James F. Moss v. Commissioner, the taxpayer worked full-time at a New Jersey power plant. He and his wife owned several rental properties — four in New Jersey and three in Delaware. When he wasn’t working at the plant, he performed activities related to the rental properties such as maintenance, rent collection and preparing the space for new tenants. The couple filed a joint return for the 2007 tax year and reported a total loss from the rental properties of $40,490 on Schedule E, Supplemental Income and Loss. The IRS disallowed $31,318 of the loss. Even though the taxpayer didn’t qualify as a real estate professional, the court allowed the couple to deduct a portion of their loss, under IRC Section 469(i). This provision allows taxpayers to offset up to $25,000 of passive activity losses against nonpassive income, provided the taxpayer actively participates in a passive real estate rental activity. This provision phases out when modified adjusted gross income (MAGI) is greater than $100,000. In this case, the court found that the husband actively participated in the rental activities, but most of the $25,000 special allowance was phased out because the couple’s MAGI was greater than $100,000. The couple sought a redetermination of their liability from the Tax Court, contending that the husband qualified as a real estate professional. As evidence, they offered a calendar he kept that detailed the dates he performed activities related to the rental properties (without noting the time spent on the activities), as well as a summary of time he spent on the activities, which he prepared after the fact in October 2009. Based on those documents, he claimed 137.75 hours traveling to and from their rental properties and 507.75 hours working on the properties — for a total of 645.5 hours. “On-call” Time Disallowed To make up the gap between the husband’s 645.5 hours and the 750-hour requirement, the couple argued that “on-call” time should be counted. They asserted he’d been on call for the properties for all of the hours he wasn’t working at the power plant because he could have been called to perform work at the properties at any time. The Tax Court rejected that argument, noting that while the husband had been on call and could have been called to perform services, he’d never actually performed those services. Therefore, his on-call time for the rental properties didn’t satisfy any part of the 750-hour service performance requirement. Because the 750-hour service requirement wasn’t met, the court found it unnecessary to address the “more than 50% test” noted above. Not only did the IRS disallow about 75% of the couple’s loss on their rental real estate activities, but it also imposed an accuracy-related penalty that the Tax Court upheld. (See the sidebar “Put in the penalty box.”) Meeting the Requirements The Moss case demonstrates the hurdles you must clear to claim the real estate professional exception that will allow you to deduct losses related to rental real estate activities. The exception is even more relevant in down markets, so consult your tax advisor for advice on how to ensure you fulfill the substantiation requirements. Put in the Penalty Box In James F. Moss v. Commissioner, substantial penalties were imposed on the taxpayers. Why were they put in the penalty box? A taxpayer may be liable for a 20% penalty on the portion of an underpayment of tax that’s either 1) due to negligence or disregard of rules or regulations, or 2) attributable to a substantial understatement of income tax. The latter is defined as an understatement that exceeds the greater of 10% of the tax that should have been shown on the tax return or $5,000. In Moss, the taxpayers’ understatement was greater than $5,000. The penalty isn’t imposed on the portion of underpayment for which the taxpayer acted with reasonable cause and in good faith or for which the taxpayer had a reasonable basis or substantial authority for the improper tax treatment. The Moss taxpayers, however, failed to show that they had so acted when deducting the losses claimed on their income tax return.

Foreclosure Investing: It's Not for the Fainthearted

Unfortunately, the number of homes being foreclosed upon continues to climb. According to online real estate and foreclosure listing service RealtyTrac, U.S. cities that lead the pack in the number of foreclosures include Chicago, Las Vegas, Los Angeles, Phoenix, and Sacramento, Calif. Flipping foreclosures may seem like a tempting investment opportunity, but it isn’t for the fainthearted. It often requires a lot of work, research and money. Surprise, Surprise! Clearly, financial and managerial difficulties drive a property owner into loan default and subsequent foreclosure. Although you may be able to snap up a foreclosed property for a reasonable price, understand that you’ll likely be investing thousands of dollars to repair years of neglect and to make the property salable. Before making an offer, research comparable MLS listings to ensure you’re not overpaying — and taking on the same headaches as the seller. Then investigate the property for other hidden surprises, including federal tax liens, partial interests, leased land, unpaid property taxes and incorrect common descriptions. To gain clear title, any mortgages will have to be paid and tax liens released. So be sure there’s enough value in the property to cover these outstanding debts. Without clear title, you could be prevented from mortgaging or selling the property. You may obtain a title insurance policy to ensure that the title is free from all defects, liens and encumbrances. Consider Your Options One way to avoid liens — and a number of other hassles — is to buy bank-owned foreclosed properties. These properties often include title insurance. And, because banks are usually anxious to jettison the properties as soon as possible, you can probably negotiate a favorable interest rate. Another option that many experienced foreclosure investors choose is to find preforeclosures — that is, property at risk of going into foreclosure. When a property owner falls behind on mortgage payments — usually for two months — the lender issues a public notice of default. The owner then has anywhere from 90 to 120 days, depending on state law, to bring the loan current. During this preforeclosure period, financially strapped owners are often willing to sell at bargain prices. You, in turn, save the owner from suffering a major hit to his or her credit rating. So it’s a win-win transaction. Scrutinize Commercial Foreclosures If the foreclosure is a commercial property, be sure to assess the property’s revenue-generating capabilities. In the case of a multifamily or retail property, that will mean poring over rent rolls and lease agreements to determine if it’s a going concern and which tenants may have contributed to the previous owner’s woes — and which leases will soon expire, thereby increasing future vacancy rates. If the property is in the warehouse or industrial sector, look at rent receipts and company financials to determine whether a current tenant will help you keep your own balance sheet in the black. Look Before You Leap In spite of all the drawbacks of purchasing foreclosed property, there’s opportunity out there to make money. Do your homework, consult your tax advisor, and then get ready for some hard work.

Before Surrendering Property, Consider the Tax Consequences

With the real estate market still sluggish, some property owners are wondering: Would they be better off surrendering their property, rather than continuing to struggle with the loan obligations? Although the answer may seem obvious, discharging debt can have significant tax consequences that should be considered. Nonrecourse Loans If you default on a nonrecourse loan, your lender’s only recourse is to seize the property that secured the loan. When you surrender property, the transaction is generally treated as a sale to the lender for the amount of debt. Your capital gain or loss equals the difference between the amount of outstanding debt and your adjusted tax basis in the property. For example, if outstanding debt is $1 million and your tax basis is $700,000, your taxable gain would be $300,000. A discharge of nonrecourse debt, however, doesn’t result in any taxable cancellation of debt income (CODI) because the lender has no right to pursue other corporate or personal assets. Recourse Loans If you default on a recourse loan, the lender can hold the corporation or the owners of a pass-through entity liable for the outstanding debt. When you surrender property financed with recourse loans, the amount of taxable gain or loss is generally equal to the difference between the fair market value (FMV) of the property and your tax basis in the property. So, if the FMV was $750,000 and your tax basis was $700,000, the taxable gain would be $50,000. In addition, CODI (calculated as the amount of outstanding debt less the property’s FMV) is realized when the debt is discharged following the surrender of the property. CODI is taxable as ordinary income. Here, it would be $250,000 ($1 million – $750,000). The Internal Revenue Code allows commercial taxpayers to exclude CODI after surrendering property in some circumstances, including:

  • Bankruptcy. CODI generally is excludable if the taxpayer’s debts have been discharged in a Title 11 bankruptcy proceeding.
  • Insolvency. If the taxpayer is insolvent before the debt is discharged, CODI generally is excluded to the extent of insolvency (determined by deducting the value of the taxpayer’s assets from its liabilities).
  • Qualified real property business indebtedness. If the indebtedness is incurred in connection with trade or business real estate, the taxpayer can elect to reduce the basis of depreciable real property rather than recognizing CODI, thereby reducing future depreciation deductions(real property held in inventory cannot be treated as depreciable real property for purposes of this provision). The reduction will be recaptured as ordinary income upon a sale.

If CODI is excluded from taxable income under one of the first two exceptions above, the taxpayer must reduce certain tax attributes to reflect the amount excluded. The taxpayer can elect to reduce the tax basis of depreciable property (including real property held as inventory) before reducing tax attributes such as tax credits or net operating losses. If all tax attributes are reduced to the point of elimination, any outstanding CODI is permanently excluded. Exceptions Not Available for Certain Entities For pass-through entities, the exceptions aren’t available at the entity level. For example, in the case of a limited liability company (LLC), the availability of the first two exceptions turns on the bankruptcy or insolvency of the members, not the LLC. In the case of an “S” corporation, however, the determination is made at the corporate level. Similarly, it’s not the LLC’s tax attributes that are subject to reduction if CODI is excluded from taxable income; it’s those of the individual members that are reduced. Surrender or Not Surrender? Surrendering property may be the best answer for you, but before doing so, tap into the expertise of your CPA advisor. He or she can help you understand-and potentially minimize-any adverse tax effects.

Ask the Advisor: How Can Lease Options Help Me in this Slow Economy?

Property owners who’ve had trouble locking down sales are offering potential buyers a gradual approach to purchasing their property — lease options. Although a lease option may not be the ideal structure for a sales transaction, it offers some attractive benefits in today’s down market. How Does It Work? Lease options — more commonly known as lease-to-own arrangements — combine a traditional lease and a purchase option. Under the option, the seller/landlord gives the buyer/tenant the exclusive right to buy the property. There’s usually a fixed price at the beginning of the lease. But the price could also be the market value on the exercise date or the amount offered by another interested buyer. The buyer can exercise the option at any time during the option period which typically runs concurrent with the lease term. The buyer generally pays an above-market monthly rent and receives a nonrefundable credit equal to a portion of the rent which is then applied toward the eventual down payment. The buyer also pays some up-front, nonrefundable consideration for the purchase option. What Are the Potential Benefits? This leasing option lets you benefit from market appreciation (if the exercise price equals market value on the exercise date) while at the same time, providing monthly cash flow that you can use to pay monthly mortgage payments and property tax bills. And, because you’re still technically the owner, you can also deduct the interest payments and property taxes. A lease option also gives the buyer/tenant a vested interest in-and an incentive to care for-the property. The greater the upfront option consideration, the greater that incentive. Plus, some lease option contracts require buyer/tenants, to pay for routine maintenance on the property. Are There Drawbacks? With a lease option, you’ll likely receive a smaller down payment if you sell the property to the buyer/tenant (because of the rent credit) than you would otherwise. Plus, monthly rental payments might not cover your mortgage obligations. An option could also keep you from offering the property for sale to other prospective buyers who might be ready to buy before the buyer/tenant, to pay for routine maintenance on the property. Worth Considering If you have property that’s been lingering on the market for some time, a lease option might be just what you need to grease the wheels on your sale and improve your cash flow. Your real estate and financial professional can show you the way.

Spotlight on Marks Paneth

NYLJ Readers Rank Marks Paneth Top Provider of Forensic Accounting Services for Second Year Readers of the New York Law Journal (NYLJ) have, once again, ranked Marks Paneth among the top three forensic accounting providers serving the New York legal community. Tax Tips for Start-Ups Tax ranks high among the many structural issues a start-up needs to consider. In her article in the Metropolitan Corporate Counsel, Alyssa Forslund, notes that even tax responsibilities that seem straightforward – such as collecting sales tax and setting up withholding for employees – can be challenging and need to be approached carefully. New Partner Joins the Westchester Office Anthony Tempesta has joined Marks Paneth as a Partner in the Westchester office. He has worked in both public accounting and industry and has more than 30 years of experience in the accounting profession. He has a deep background in the nonprofit and government sector. He also serves real estate entities, closely held businesses and high-net-worth individuals. Immediately prior to joining Marks Paneth, he was the president and managing partner of his own firm, Tempesta & Farrell, CPAs, P.C., for 15 years. Long Island Business News Highlights Marks Paneth An article in a recent supplement to the Long Island Business News focused on how the firm enables our business clients to do what they do best.

For Further Information

If you have any questions, please contact Harry Moehringer, Partner-in-Charge of the Real Estate Services Group at 212.503.8904 or hmoehringer@markspaneth.com or any of the other partners in the Marks Paneth Real Estate Services Group:

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