Court Says Mortgage Broker Not a Real Estate Professional

The passive activity loss rules can prevent real estate investors from being able to deduct their real estate losses.  That is the intent and purpose of the rules.  The rules and how they have been interpreted draw some known but arbitrary lines in the sand.  The recent Hickam v. Commissioner, T.C. Summary Opinion 2017-66, case addresses one of these arbitrary lines, i.e., whether a mortgage broker who lends money for real estate is a real estate professional.

The Facts and Procedural History

The taxpayer was a mortgage broker.  This mortgage brokerage work was performed as an independent contractor.  He also worked another company as an employee originating loans.  This work involved brokering and originating mortgage loans for clients to buy real estate; refinance existing loans; and secure reverse mortgages, commercial loans, and, occasionally, construction loans.

The taxpayer also owned several rental properties that he managed, including two single family homes and a nine unit apartment complex.

The rental real estate produced a tax loss in 2011, and 2012.  The taxpayer elected to group the properties as one property on his tax returns.  The taxpayer reported a combined loss from the three properties of approx. $40,000 in 2011 and again in 2012.

The IRS audited the taxpayer’s returns and disallowed the loss as passive activity losses.  More precisely, the IRS determined that the taxpayer did not qualify as a real estate professional.

The Passive Activity Loss Rules

The passive activity loss (“PAL”) rules were enacted to discourage taxpayers from entering into tax shelters.  Many of these pre-1986 tax shelters involved real estate, so real estate was specifically included in the PAL rules.  Under these rules, rental real estate is deemed to be passive and any loss is generally limited to other passive income.  Unused losses are carried forward indefinitely until there are passive income or the passive activity is sold or disposed of.  These rules can prevent a taxpayer who has other non-passive income (such as wages from a job), from taking the passive losses from real estate to reduce non-passive income that is subject to tax.

The Real Estate Professional Exception

The PAL rules include an exception for real estate professionals.  Real estate professionals are individuals who own real estate and who spend more than half of their time during the year tending to the property and who do this for more than 750 hours a year.  These rules can be particularly problematic for individuals who have a regular job or unrelated businesses, as they often will spend more time with their job or business rather than their real estate activities.

This isn’t necessarily true for individuals whose jobs or businesses are related to real estate.  The PAL rules define these real estate related businesses as follows:

the 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.

The IRS has previously issued guidance in 2014 suggesting that this language does not include individuals who work providing financing for real estate that they do not own.  This brings us to the Hickam case.

The Court’s Holding

The taxpayer in Hickam argued that his mortgage brokerage services and his loan origination services are performed in trades or businesses in real property operation because the underlying assets in both services are real property.  The court did not agree.

The court concluded that the underlying asset is real estate is not sufficient.  To the court, the focus is on the activity and for the term “operating,” the taxpayer had to operate the real estate.  So real estate financing activities for property the taxpayer did not operate do not qualify.

The result is not surprising.  It is consistent with the general understanding of these rules.  But the facts of the case are very close to the line.  It would have been interesting to see what the court would have done if the taxpayer in Hickam had served as the broker for his own properties.  It is not clear how the court would rule given that fact.

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