The Lawletter Vol 39 No 7
A recent decision by the U.S. Tax Court illustrates the difficulties that can be encountered by taxpayers who want to avoid the special rules that apply with respect to the deductibility of losses from "passive" business or investment activities. In Schumann v. Commissioner, T.C. Memo. 2014-138, 2014 WL 3408198, the Tax Court ruled that since an individual who invested in rental real estate was not a "real estate professional," the deductibility of losses that he sustained in connection with his rental property activities and investments was subject to the passive activity loss rules that are set forth in § 469 of the Internal Revenue Code.
Section 469 of the Code generally disallows any passive activity loss for the taxable year in which the loss was sustained and forces the taxpayer to treat the loss as a deduction or credit for the next taxable year. "The term 'passive activity' means any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate." 26 U.S.C. § 469(c)(1). "Except as provided in [§ 469(c)(7)], the term 'passive activity' includes any rental activity." Id. § 469(c)(2).
Under § 469(c)(7)(B), rental activity on the part of a taxpayer does not constitute passive activity if
(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Id. § 469(c)(7)(B)(i)-(ii). "[T]he term 'real property trade or business' means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business." Id. § 469(c)(7)(C).
A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—
(B) continuous, and
Id. § 469(h)(1).
In Schumann, the Tax Court concluded that the taxpayer did not meet his burden of proving that he "materially participated" in any real estate activity during the tax years in question. 2014 WL 3408198, at *8. In reaching its decision, the court noted that the taxpayer failed to sufficiently document or otherwise prove that he spent the requisite amount of time on his rental real estate activities to avoid being subject to the passive activity loss rules.
The Schumann decision should be taken as a warning by the Tax Court that if a taxpayer engages in rental or other real estate business activities and wants to avoid having such activities be deemed "passive" in nature by the IRS, he or she should take care to document the time actually devoted to a real estate trade or business in order to be able to establish his or her "material participation" in the trade or business. For an excellent summary of the Schumann case, see 60 Fed. Taxes Wkly. Alert (Thomson Reuters) art. 15 (July 31, 2014).