In Episode 31 of How Tax Works, Matt Foreman revisits the passive activity loss limitation rules that he discussed in Episode 13—but from the view of real estate investors. The episode focuses on the additional rules for rental real estate, as well as practical tips to survive an audit.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 31st episode of How Tax Works. I’m Matt Foreman. In this episode, I will continue episode 13. That worked out nicely. Episode 3113 of how tax Works Passive Activity loss rules under section 469, where the continuation goes, is specifically real estate professionals. Real estate rental professionals. Right.

Matthew Foreman [00:00:31]:
Which is the bulk of them. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. Before we get started, a few administrative things. New episodes every two weeks. The next episode we’ll discuss.

Matthew Foreman [00:01:00]:
I’m not sure. It’s probably going to be whether AI is any good at tax advice. I got a really good idea for it, but candidly this is. This is going to record it in about a month. So things may change by then. I might decide not to do it. I might not have time to do this. This one’s a little more involved, but I got ideas anyway.

Matthew Foreman [00:01:17]:
If you have any questions, comments or constructive criticism, you can email me at my FRP email address. Upcoming webinars and speaking engagements are on the How Tax Works landing page on the FRB website. Now let’s talk about some passive activity loss rules under section 469 of the Internal Revenue Code for Real estate professionals. Before we begin, just, I think to be candid, you should listen to episode 13 of this podcast first. I am going to basically ignore every absolutely everything in it except for things that I want to repeat. And I’m doing that because I’m assuming we all know what happens when you assume that you listened to episode 13. After that episode, I got an email from an accountant who said, hey, how about the 750 hours? And more than anything else, I’m not naming names. They know who they are and they’re right.

Matthew Foreman [00:02:05]:
Which I told them at the time. Look, I told them I needed a second episode. I had to keep that one under 30 minutes. And I thought both of these were 20, 25 minute topics. So we’re going to do it. So we’re getting into it now. I’ve decided to come back to it. I knew I would, but I need to sit down and do it.

Matthew Foreman [00:02:21]:
There are additional requirements. So at a high level. 469 the idea is that if you are not actively involved in the trader business, whatever it may be, and there’s rules for what’s active. You are passive and you cannot use passive losses to offset active income or investment income. The reason is people did this in 1986. This, this was a huge change to the tax rules if they really wanted to just like, open things up. Like, this would actually be a really easy thing to repeal and would just be a incredible giveaway, but it’d probably be unpopular. This is actually.

Matthew Foreman [00:02:55]:
I mean, the num. The amounts are just gigantic. And anyway, so, you know, first off, people say, I’m saying, oh, these are additional requirements for real estate professional in rental real estate. And they say, well, I don’t rent, I lease it to people. Cool. Yeah. Rose Banner, their name. Move on.

Matthew Foreman [00:03:10]:
Whatever. Rental real estate is per SE passive under 469 C2 as of starting in 1986. In the early 90s, Congress kind of looked at this and went, that’s a little bit nasty. That’s a little much. So they passed 469 starting. It was effective in 94 later. So I assume it was passed in 93, although admittingly, I don’t actually know. I didn’t write that part down.

Matthew Foreman [00:03:34]:
And it imposed two additional requirements to not be passive in rental real estate. First, more than one half of the taxpayer’s total personal services during the tax year, and this is measured on a year by year basis during the tax year must be performed in real property in a real property trade or business in which the taxpayer materially participates. I break that down into three requirements. Okay, More than one half of your personal services. Total, total personal services, two. Must be in the real property trader business. Three and you must materially participate in the real property trader business to include it in the numerator. Otherwise, you’re in what I call the 500100 rule, which is in Treasury Reg.

Matthew Foreman [00:04:16]:
1.4695 T. A1 through 7. I will quickly go through them, but again, listen to them from episode 13. The first one is activity for more than 500 hours. Second one is substantially all of the activities for is done by this one individual for the tax year. 3. Individual participates more than 100 hours and is not less than any other individual participant. Four, taxpayer spends at least 100 hours in a variety of different activities and together the total participation is greater than 500 hours.

Matthew Foreman [00:04:51]:
Five, the individual materially participated at least five of the last ten years, though not necessarily consecutively. Six activities of personal service activity and the individual materially participated at least the three preceding at least three preceding years, though not necessarily. And seven based on the facts and circumstances. Don’t. Don’t rely on facts and circumstances. Just don’t. It’s stupid. I probably said that in 13 too, but man, that’s a.

Matthew Foreman [00:05:19]:
That’s risky. Anyway, the second requirement. So the first one is more than half your taxpayer’s total personal services. The second one, okay, the first one is under 469C7 cat B Roman at one. This one’s in 469C7 cat. B Roman at two. All of those hours in the numerator that are in the one half test, those hours must exceed 750 hours. 750.

Matthew Foreman [00:05:44]:
It is not, not a tiny number. Okay, so that 500. Oh, I got 500. Ha ha. No, no, no. You need 750 and you need more than half of your total hours. So if you have another job, which I’ll talk about later, you’re going to have another. Going to have a big problem.

Matthew Foreman [00:05:59]:
Unless you really are a real estate professional. In rental. Okay, there is an exception, a really, really nice one. Short term rentals and a number of others. Basically they’re not considered a rental if you meet one of them. There are six. They are in treasury regulation 1.4691 T E3 Romanet 2 Cap A through cap F. All right, the first one, the average period of customer use the property is seven days or less.

Matthew Foreman [00:06:26]:
Think Airbnb. Right. What is the average? So there are people who intentionally make less money, less revenue because they want to keep their average period of customer use to seven days or less. There may be a month in there, but if you have a month, you got to have a lot of three day rentals. Two, the average period of customer use in the property is 30 days or less. And significant personal services are provided by or on behalf of the property owner in connection with making the property available for customer use. So 30 days or less. But they have a butler.

Matthew Foreman [00:06:58]:
I’m not totally sure what the significant personal services are and I’m not going to go through that in detail. I don’t think it’s necessary. Three extraordinary personal services are provided by or on behalf of the property owner in connection with making the property available for customer use for the rental. The property is incidental to non rental rental activity of the taxpayer. All right, don’t know what that means, but that’s really important. Sure, there’s litigation on that. Five, the taxpayer customarily makes the property available during defined business hours for non exclusive use by various customers. I like rental bikes in that one.

Matthew Foreman [00:07:31]:
That’s the one I always think of. But that’s not real estate rental anyway so it doesn’t really matter. So you know, we’ll see. And six, you know, maybe that’s short term hotels and six the taxpayer, you know. Four the rental of the property is incidental to the non rental activity of the taxpayer. Man, that would, this is getting dirty here. That’d be a brothel, wouldn’t it? Right. 6 the taxpayer provides the property for use in non rental activity conducted by a partnership, s corp or joint venture in which the taxpayer owns an interest.

Matthew Foreman [00:08:02]:
Okay, so it’s used for a non rental activity. I don’t know. I an interesting one there. So I’m not going into what those are but those are some exceptions. I wanted to mention them because I think they’re important. All right, we’re going to take a couple minute break and then we’re going to come back and we are going to talk about the more than 50% required. All right, I’m back. Let’s, let’s talk about the more than half requirement.

Matthew Foreman [00:08:38]:
Right. So again additional requirements for real estate professional 469 C7B CAT B Romanette 1 more than half the personal services are real property trader business. You must materially participate in that real property trader business to include enumerators. You can’t just have a whole bunch. You don’t materially participate unless you, you can group them together. Right. The grouping rules are really interesting. Not doing the grouping rules.

Matthew Foreman [00:09:02]:
I think that’s going to be the next one. Maybe I’ll do that one in another 18 or so episodes. So first and foremost the taxpayer is the burden of proof. Keep a log, keep your emails. Half a separate phone, half separate email. Have a separate WhatsApp account. You know, keep that there. This is CO NV Commissioner 39 Fed Second 540 I literally talked about this at the end of the last episode.

Matthew Foreman [00:09:23]:
So if you’re listening to these episodes in bulk, first off, I’m sorry secondly, like you’re up on it but like substantiation is really important. Simply having a spouse who is a real estate broker does not help you otherwise qualify inclusion under the standard for material participation under 469.5ta. I repeat myself because it matters. Right? You know the key, the key though is if you’re bringing these in, right, you get real estate and this and that. It’s still rental. You know, you have to get around the rentals rules. So there still must be some rental. More than half.

Matthew Foreman [00:09:55]:
There’s a bunch of cases on this. I Think it’s really important. I’m going to repeat myself a little in these, but I think it’s important. Wyndham TC memo 2017-68. That one, the taxpayer worked 12 and a half hours a week as a stockbroker. That one the taxpayer came out ahead. You know, it’s pretty easy to say you work 12 and a half weeks and oh look, I went 25 hours a week on real estate. That’s my life.

Matthew Foreman [00:10:16]:
Great. Congratulations. That works. Harnet TC Memo 2011191 Mr. Harnett here, man, was he ever a liar. CEO and chair of a bank. He said he worked 10 hours a month and the court found it not believable due to the requirements for his position what he actually had to do. I will tell you that I’ve dealt with these in practice in audit and the IRS and states don’t really believe you generally.

Matthew Foreman [00:10:44]:
Right. So you have to prove to them and I think this is a reasonable proof. Taxpayers may, my clients may disagree on this one, but reasonable burden of proof that you have to be able to prove that like that’s actually how much you worked in your job and it’s reasonable for you to have worked in that job. Right. If you can log every hour and have everything like that, you’re fine. Most people don’t work that way. Mostly don’t log their hours. You know, fortunately for them as someone who logs his hours.

Matthew Foreman [00:11:10]:
So I think it’s really important to be able to show that you actually work that many hours. They just did not believe. Harnett, dude, you’re the CEO and chairman of a bank. How did you work 10 hours a month? These are your job title. This is your. This. They had actual things he had to do. That’s not 10 hours a month.

Matthew Foreman [00:11:24]:
They just didn’t believe him. Lee TC Memo 2006193 they were two brothers. One is named Kai. Kai and one had a name. I do not recall it, but it was a, it was a heck of a name. Someone look it up. I’m not gonna. Brother A was full time employment the IRS and brother B owned a medical diagnostic business.

Matthew Foreman [00:11:47]:
Right. I want you to imagine you’re a full time employee of the Internal Revenue Service and you’re like, yeah, yeah, yeah, yeah. Don’t worry, I spend more than half of my time doing other things. Oh, and by the way, I work seven. I’m full time employee at the IRS and I work more than half my time on other stuff. I don’t remember the totals, but they Were just not believe, you know, they were, they were working 4,4000 hours a week and yeah, I didn’t, I didn’t. It’s funny, the IRS didn’t believe it either. I thought that was really funny for, for either brother.

Matthew Foreman [00:12:14]:
So they didn’t do well. Penley is one of the more fascinating cases. TC memo 2017-65. You’ll notice these cases are fairly recent. They’re all within the last. Decided within the last 20 years. There are so many. You’re only going to get these from 86 current generally and really from 94 current relating to real estate professional status.

Matthew Foreman [00:12:36]:
Probably 1990 current or yeah, 2000 current. Because if the law started in 94 returns filed in 95 first time it’s going to hit tax courts three, four or five years later. Anyway, Penley, right, he worked 2194 hours in non real estate and 2520 hours in real estate. So he told the IRS with the straight face that I work 4700 hours a year. Do you know how many hours that is a day? 13. Roughly 13 hours a day. 365 days a year. That is possible.

Matthew Foreman [00:13:13]:
That is plausible. That is beyond unlikely. Sitting there eating breakfast for 10 minutes. Are you working when you are thinking about your real estate portfolio? Sure. Are you working when you’re really thinking about your real estate portfolio for 469 purposes? Probably not. Probably not. I’m sure the IRS would say absolutely not. They just didn’t believe it.

Matthew Foreman [00:13:38]:
The thing that irks me about these cases is a lot of them are just so implausible and they do it. I had a client who asked me why is every case bad for the taxpayer? I said, well, not every case is. And I said, I’ll tell you why. Because the IRS isn’t going to litigate good cases. They’re not probably not even going to litigate mediocre cases. Right. I was actually pretty surprised that they litigated Wyndham. There must have been something else there because they tend to smoke people.

Matthew Foreman [00:14:03]:
The reason that they litigate and I’ll get back to a couple cases in a moment. The reason they litigate bad case. They litigate bad cases is because they want really broad tests that say what are you doing? Don’t do that. If you have good facts, they’re either A going to settle with you or B, they’re just not going. They’re gonna you’re win on audit or once you get in council, whether it’s in appeals or you file the case of the tax Court, they’re going to say, well, I think we can work something out here, right? Or limit it to other facts or other issues. You know, sometimes these. You have a 469 issue and you have other things. All right, another case.

Matthew Foreman [00:14:37]:
H A K K A Y Hake Hacke. I apologize. I don’t know how to say the gentleman’s name. Tax court memo 2020-46. He was a solo lawyer. He said he worked very few hours as a lawyer. He also had some fairly serious health problems, which are somewhat discussed in the case. Not fully during the years at issue.

Matthew Foreman [00:14:57]:
They, they cited in it, you know, look, he says, I just worked really few hours as a lawyer. And they, they basically came back with two things. One, we don’t think you work this. This few of hours. He was a. I think he was personal injury lawyer. So he didn’t keep his logs. But they basically said, we don’t actually think.

Matthew Foreman [00:15:12]:
We don’t know if you worked, you know, 2,000 hours or a thousand hours. We don’t think you work that many hours as a real estate professional. Professional. He couldn’t show those either. So, like, if you’re gonna say, well, I worked, you know, more in the other one, you have to show you worked both. Right. Hairston tax court memo 2019, 104. Keep realistic logs contemporaneous.

Matthew Foreman [00:15:33]:
His logs included 13 hours for paying the mortgage. Look, I get it. No one wants to pay the mortgage. It’s really annoying, it’s very frustrating, etc. Etc. But like, come on, man, really? I think it was Harrison, but I’m not sure. There’s also a case where they use the house as like a rental. And like, they spent 24 hours consecutive in 24 in a single day doing something that takes like two hours shoveling or like painting a room or something like that.

Matthew Foreman [00:16:03]:
Like, you’re not going to spend 24 consecutive hours painting a room. Maybe if you’ve done amphetamines and you’re just running around like, you know, just going nuts because you’re so amped up. I don’t know. This is a really off, off, off color one. So I apologize in advance. You know, I think, I think that’s the key one for that one, you know, look, Cohan requires better than a ballpark guesstimate, ballpark estimate. Moss 135TC365. You have to.

Matthew Foreman [00:16:31]:
It has to be realistic. You know, you can’t do that. So that’s important. All right, number six. This, this is the last big point. But I’m going to go into some detail on this one. 750 hours. What is included in those 750 hours and what is not? The IRS will tell you certain things.

Matthew Foreman [00:16:52]:
And the tick tock and Instagram influencers who are trying to sell you on having a grand tour trust to own your real estate inside an S corp or whatever, I probably flipped that, but maybe not isn’t going to do it. So look, go back to episode 13, right? I talked about 500 out. I talked about the 500 hours. Generally speaking, the things I talked about within the 500 hours, those are also includeable in 750. But I think there’s some additional detail that I think is important. All right, I am now going to and I apologize in advance, I’m going to read this, okay, 469C7C that says for purposes of this paragraph, which is caps for 469C7CAP C the term real property trader business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage or trade or brokerage, trade or business acquisition. Right? So the question that comes up is the prospecting. The IRS hates it, hates it, hates it, hates it.

Matthew Foreman [00:17:53]:
But the preamble of the section in the 163 Regulations TD 990585 FR 50, paragraph 56, 686. The Treasury Department IRS generally agree with the observation that real property construction, construction, reconstruction, development, redevelopment, conversion, acquisition or brokerage business should not necessarily be required to have a direct nexus or relationship to rental real estate in order to be treated as real property trades or businesses. However, the expectation nevertheless remains that the end products or final objectives of such businesses should should at least have the potential to be used as rental real estate or as an or as integral components in the rental real estate activities. Get that eventually. This one is, look, they’re prospecting. I have to go find my next building. I define my next building. The IRS hates it.

Matthew Foreman [00:18:43]:
Look, if you’re doing it before you’re in the business as a real estate professional, you’re just not going to get it. Really not. No. Research and Preparatory Activities Almquist TC Memo 2014-40 so it’s not yet commenced. I think that’s really important if you can’t connect it to other activities. Bougarin B U G A r I N vs Commissioner TC Summary Opinion 201361 There’s a lot of cases that talk about these. Those are some good ones, I think. But what if you’re already in it, right? You already own A couple businesses.

Matthew Foreman [00:19:16]:
You already have a couple things, a couple ones. You’re looking for that next one. You have 14 homes, you’re looking for the 15th in the same area, Right. You know, find you’re already, you’re already doing it, Right. This one, I think is a very different, very different fact pattern. Plainly simple. And I’ve said this, I’ve said this to the IRS. Hours spent searching for properties can count toward the 750 hour requirement.

Matthew Foreman [00:19:40]:
Hail Stock V. Commissioner TC memo 2019 104. This one, the taxpayer spent time researching prospective properties and it counted toward qualification as a real estate professional. In TD 9905, it says that activities that by themselves do not rise to the level of real property rental activities, such as a triple net lease, they can be property, real property activities if there are a sufficient number. The act itself of prospecting or looking for new properties may not qualify by themselves. However. However, you’re looking for ones that are voluminous, regular, continuous, substantial, and therefore they must be included. Right? So if you have someone who has 13 buildings are looking for that 14th, it may, right.

Matthew Foreman [00:20:23]:
If that person spends 900 hours looking for their next, next house to rent. Maybe not. Maybe not. If they spend 150 or 200 hours a year and then a thousand otherwise running their business. Yeah, I mean, that may, depending on what they’re doing. Okay. And I think that’s a really, really, really important one. One.

Matthew Foreman [00:20:41]:
So, you know, 750 includes prospecting. But I will give a caveat as I bring it all home. All right, let’s say you got two rental properties in Massapequa, New York. It’s on Long island for those scoring at home. And you’re like, oh, yeah. Then I, when I take my family vacation to Milan, I look at a commercial building, right? You have two $700,000 houses and you’re looking at a 14 million dollar piece of commercial real estate. My friend, that does not qualify. It’s a different character.

Matthew Foreman [00:21:11]:
It’s totally different. And you’re writing off your entire family’s flight and the hotel. Look, if you live in New York and you’re buying real estate in State College, Pennsylvania, you can fly off, you can write off your flight to State College, which there may be one, I don’t know. You can definitely write off your drive back and forth if that’s what you’re doing, assuming you meet other requirements. But reasonableness and calmer heads have to prevail on this, okay? Because you see ones and they’re like, look, I write off all my vacations. I write off all my meals. No, don’t. Don’t write off meals.

Matthew Foreman [00:21:48]:
As a real estate professional, write off of maybe a few if you’re having a meeting, if you’re doing something like that. But it’s important to note that ordinary necessary doesn’t mean that it’s, you know. Well, I have to eat, and I was eating during my day of work. Congratulations. So do we all. All right, so you don’t do that. And I think this is a case where if you have good facts, you don’t want to muddy the waters by being piggish and by being excessive. And if you have bad facts, doing things like this will only make it worse.

Matthew Foreman [00:22:19]:
So when I see situations and I’ve had these conversations with clients and prospective clients over the years, and I’ve seen it where they’re like, oh, yeah, you know, I flew, you know, I have this real estate. I have a 7 million dollar portfolio into the New York metropolitan area. And I, you know, when I took my vacation to Singapore, I looked at real estate with a broker out there. Did you buy anything? No. Okay, well, you’re not adding that time to your 750 hours because it’s not in and of itself a qualifying activity because it’s just so different. It’s outside of the fact pattern, to be honest. You wouldn’t group the activity in it anyway, so it might not meet, you know, so I think that’s. That’s a problem.

Matthew Foreman [00:23:01]:
Anyway, thank you. That was episode 31 of how tax Works. I hope you learned something. I’ll be back in two weeks, episode 32, where I’ll be discussing, most likely whether AI can give coherent and accurate tax advice. I think the answer is kind of maybe. It depends. A lawyer, so it depends. Right.

Matthew Foreman [00:23:19]:
On that note, the best song of all time. Thank you for listening.