Federal Income Tax
Houston Tax Attorney
There are a lot of questions about the new Sec. 199A pass thru deduction. One question is whether real estate will qualify as a trade or business. Since it is not defined in Sec. 199A, general tax law will apply. There are a number of court cases on point. The court recently issued its opinion in Levitz v. Commissioner, T.C. Summary Opinion 2018-10, which provides an opportunity to consider whether real estate rises to the level of a trade or business and what needs to be documented to make this showing.
Facts & Procedural History
The facts and procedural history are as follows: The taxpayer is a lawyer. After graduating from law school, the taxpayer and his friend attended real estate classes. They eventually purchased a condo, renovated it and sold it. They joined the local real estate group and would occasionally attend the monthly meetings. The taxpayer received five certificates from the Certified Commercial Investment Member (CCIM) Institut for completing real estate courses.
The taxpayer and his friend established two real estate entities, which had their own checking accounts but no employees. The entities got involved in six real estate purchases, with the intent of purchasing the properties, remodeling them, and selling them.
The taxpayer’s friend moved to Texas in 2008 and, after 2008, the taxpayer abandoned his real estate activities.
The taxpayer’s 2008 tax return reported the sale of his real estate as capital losses on Sch. D. The losses were subject to the capital loss limitation rules.
After audit, the taxpayer filed a petition with the U.S. Tax Court asserting that his capital gains were actually fully allowable as ordinary losses.
Real Estate Trade or Business
The court summarized the law as follows:
The Code does not define the term “trade or business”. To be engaged in a trade or business, “the taxpayer must be involved in the activity with continuity and regularity and * * * the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). “A sporadic activity, a hobby, or an amusement diversion does not qualify.” Id. Whether a taxpayer’s activities constitute the carrying on of a trade or business requires an examination of the facts and circumstances of each case. Id. at 36. The management of one’s investments, no matter how extensive, is not a “trade or business.” Whipple v. Commissioner, 373 U.S. 193, 200 (1963).
Factors indicating that the taxpayer conducted real estate activities in a systematic and businesslike manner support a finding that he was engaged in a trade or business. Norris v. Commissioner, T.C. Memo. 1991-648, 62 T.C.M. (CCH) 1652, 1656 (1991). The Court also considers whether the taxpayer maintained books and records for that business. Evans v. Commissioner, at *28; Norris v. Commissioner, 62 T.C.M. (CCH) at 1656 . The commingling of personal and activity funds is not indicative of businesslike practices. See Dodds v. Commissioner, T.C. Memo. 2013-76, at *15; Ballich v. Commissioner, T.C. Memo. 1978-497, 37 T.C.M. (CCH) 1851-40, 1851-46 (1978).
The Factual Nature of this Determination
Given this law, the court concluded that the taxpayer’s real estate activities were not a trade or business. The court’s conclusion was based on the following:
- The taxpayer did not provide any evidence or estimate for the time he devoted to real estate.
- The taxpayer had an active law practice in 2008.
- The taxpayer did not keep books and records in a manner consistent with a trade or business; the records provided were disorganized and did not appear to be kept in a systematic and businesslike manner.
- The taxpayer did not file a Schedule C or an income tax return for the real estate activities for 2008.
- The taxpayer provided only vague details about the management of the real estate activities.
- The taxpayer did not hire any employees for his real estate activities.
- The taxpayer did not maintain an office for the real estate activities.
- Some of the real estate expenses were paid from the taxpayer’s personal bank account.
The Sec. 199A Pass Thru Deduction
As mentioned at the top of this article, this law may have to apply for the new Sec. 199A pass thru given the absence of other rules. There is a chance that the Treasury may issue regulations or guidance in this area at some point. In the absence of regulations or other guidance, these factors are critical for real estate businesses–particularly those with real estate gains and not losses. These factors may very well dictate whether the taxpayer is able to deduct 20 percent of their real estate income.
With this in mind, taking a closer look at the factors the court considered important, what if the facts were closer? What if the evidence established that the taxpayer satisfied two, three, four, etc. of these eight of these factors? How many factors are needed to get to a filing position for the Sec. 199A deduction? Perhaps the answer is that taxpayers should take steps now to satisfy all of the factors.
Many of the factors do not appear to be difficult to satisfy. But this highlights the problem. The factor that looks to the time spent in real estate will be difficult for most taxpayers to document.
One only has to look to the disputes over the material participation and real estate professional rules to see how this will play out. With those rules, at the examination level, the IRS often takes the position that anything short of detailed timekeeping records is insufficient. The IRS has taken similar positions in court.
One cannot help but pause to wonder if this is what Congress intended for the Sec. 199A deduction? To tempt taxpayers with a 20 percent deduction and then only have the deductions taken away on audit. This would seem to fall short of the economic stimulus Congress promised.Previous post: Documenting Loans to Closely-Held Corporations
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