Tax Day approaches.  I know many folks are putting in the hours on preparing tax returns this week … or else putting in the minutes filing Form 4868.  But we all know—especially when unhappy clients come to us to fix a return messed up by some whack-a-doodle preparer—just putting in hours in filing tax returns does not make one a tax professional.

In Robert L. Drocella and Pamela M. Drocella v. Commissioner, T.C. Summ. Op. 2023-12 (Apr. 3, 2023), Judge Leyden teaches us, and our clients, that simply putting in the hours working on one’s rentals does not make one a real estate professional for §469 purposes.  There the hard-working taxpayers were not allowed to escape §469’s prohibition on taking passive activity losses against active income even though they together put in over 1,500 hours in working their six rental properties.  We learn today there are two other tests to being a real estate professional and these taxpayers failed one of them:  they were unable to show the Court the how the hours they worked their rentals related to the hours they spent earning wages.  Details below the fold.

Law: Section 469 and Real Estate Professionals
Congress added §469 to the Code in the Tax Reform Act of 1986, Pub. L. 99–514, 100 Stat. 2085, 2233.  The idea in §469 is that there are two ways taxpayers earn income: they either actively work for their income or else they passively sit back and let others work it for them.  Congress had become suspicious that the latter situation, finding that taxpayers would invest in activities that had no economic substance beyond generating tax benefits (generally paper losses).  Taxpayers would then use those losses to offset their actively earned income, often from high salaried positions.  See Joint Committee Staff, “General Explanation of Tax Reform Act of 1986” (“JCT Bluebook”) (May 4, 1986) at 209-215.

To fix the problem §469 first differentiates income (and losses) incurred by each type of activity:  income and losses earned from active work go into one bucket; income and losses received from passive activities go into another bucket.  The statute then creates a like-to-like rule: passive activity losses (PALs) may only offset passive activity income.  They may not be used to offset income from activities where the taxpayer actually work for their income.  Unused PALs may be carried forward into the next year. §469(b).  There are also lots of other fun rules that are not relevant to today's lesson.

So what’s the difference between an active income-producing activity and a passive one?  Well, §469(c) tells us, by defining what constitutes a passive activity.  The general definition in (c)(1) says that passive activities are those in which the taxpayer does not materially participate.  The idea here is that a “taxpayer who materially participated in an activity [is] more likely than a passive investor to approach the activity with a significant nontax economic profit motive, and to form a sound judgment as to whether the activity had genuine economic significance and value.”  JCT Bluebook at p. 212.

Following its general definition of passive activity  §469(c) lists specific types of passive activities.  For today’s lesson, we focus on §469(c)(2) which tells us that “any rental activity” is passive per se.  Section 469(c)(4) then says that rental activities are passive regardless of whether the taxpayer materially participates.  Apparently “any” does mean “any.”  Except, of course, it does not.  There are two situations where a rental activity might actually not be a passive activity.

First, the regulations clarify that “any” does not include short-term rentals.  Thus, if the average rental period is 7 days or less those are not automatically passive under §469(c)(2) but are instead governed by the material participation standard.  See Treas. Reg. 1.469-1T(e)(3).  For more details, see Lesson From The Tax Court: Why Vacation Home Losses Are Difficult To Deduct, TaxProf Blog (Oct. 7, 2020).

Second, as relevant for today, §469(c)(7) provides that rental activities of certain types of taxpayers are not passive activities.  What kind of taxpayers?  Well, most people (including Judge Leyden) call them real estate professionals.  I’ll call them that as well.  Section 469, however, does not use this term.  Instead, it focuses on the taxpayer's relationship to something called a "real property trade or business."  That term is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”  §469(c)(7)(C).  As I teach it, the statutes creates three tests to determine whether a taxpayer's relationship to that activity qualifies for this exception to the per se rental rule:

(1) Proportionality test: the hours that the taxpayer puts into that real property trade or business must be more than half of all the hours that the taxpayer puts into their active activities.  §469(c)(7)(B)(i);
(2) Hours Worked test: the taxpayer performs more than 750 hours of services during the taxable year in that real property trade or business.  §469(c)(7)(B)(ii); and
(3) Material Participation test: the taxpayer materially participates in a “real property trade or business.” §469(c)(7)(C).

Married couples filing joint returns are allowed to combine their efforts to determine if they meet the Material Participation test, §469((h)(5), but not the other two tests.  That is, Treas. Reg. 1.469-9(c)(4) says that one spouse must separately satisfy both the Proportionality test and the Hours Worked test.

As you might expect, all of this requires the taxpayers to prove up their hours.  But they must be prepared to show more than just how many hours they put in to the rental.  In order to show they meet the Proportionality test, they must also show how many total hours they put into their other work.  Treas. Reg. 1.469-5T(f) gives the rules but the basic idea is that taxpayers must substantiate with adequate records, and contemporaneous records are the best.

Facts
The tax year at issue is 2018.  That year Mr. Drocella worked full-time for Northrup Grumman.  Ms. Drocella worked full-time for the U.S. Department of Defense.  They did not, however, stipulate with the IRS or show the Court how many hours they worked at their full-time jobs.  Absent that, we might reasonably assume it was 2,080 hours for the year since that is a typical (but not the only) number used to calculate Full Time Equivalents (FTE).

In addition to their full-time employment, the Drocellas owned and managed six rental real estate properties.  That consumed a lot of hours, which they did track.  They kept a handwritten work log where their recorded their time.  The log reflected over 1,500 total hours worked in 2018.  The log further reflected that Mr. Drocella put in over 750 hours and the Ms. Drocella put in less than 750 hours.  Op. at 2.  The opinion does not say how many hours each spouse claimed to have worked, but for reasons that will become apparent, one must assume that Mr. Drocella's documented hours did not exceed 1,040.

On their 2018 return, the Drocellas reported their rental real estate activity on a single Schedule E and there showed a loss of just under $63,000.  The opinion is silent on the details of the loss.  Their Form 1040 showed an AGI of $160,000.

The IRS denied the real estate loss deduction because it decided the rental activity was a passive activity.  Therefore the losses were Passive Activity Losses (PALs) and could not offset the Drocellas’ active income from their full-time employment.  The Drocellas disagreed and petitioned the Tax Court.

Lesson: It Takes More Than Just Putting in the Hours
The Drocellas argued that they were real estate professionals because they put in the required hours.  In rejecting that argument, Judge Leyden teaches us that qualifying as a real estate professional for §469 purposes means more than just putting in the hours.  It means meeting all three of the tests: the Proportionality test; the Hours Worked test; and the Material Participation test; .  Flunk one and the rest do not matter.

Here, Judge Leyden finds that the Drocellas failed the Proportionality test.  Thus, regardless of the hours they worked on the rentals, they could not qualify as real estate professionals and the rental losses were PALs.  The Drocellas simply failed to establish that the hours each one put in to the rentals amounted to more than one-half of the hours each put into their full-time employment.  Remember, to meet the Hours Worked test, married taxpayers cannot combine their hours.  One or both must put in over 750 hours.  Here, Judge Leyden notes that only Mr. Drocella even met the Hours Worked test.  Op. at 2.  But their failure to prove how many hours they actually worked for their employers meant that they could not show Mr. Drocella met the Proportionality test.

Critical to Judge Leyden’s decision was her finding that “neither petitioner has provided the number of hours he or she performed as an employee.”  Op. at 4.  Thus, “petitioners cannot prove that more than one-half of either petitioner’s total personal services performed in trades and businesses were performed on their rental real estate activities during that year.” Op. at 5. 

For example, if Mr. Drocella had been able to show that he worked at Northrup Grumman for 2,080 hours, then he could qualify as a real estate professional if he could also show that he put more than 1,040 hours into the rental activity and materially participated in it.  Same for Ms. Drocella.  So that is why we must assume that his hours totaled less than 1,040 on the handwritten log.

Once she decides that the Drocellas failed the Proportionality test, Judge Leyden declines to wade into the questions of whether their handwritten logs accurately tracked their hours or whether either or both of them materially participated in their rental activity.  Those issues simply did not matter because taxpayer must meet all three tests to be real estate professionals.

Bottom line: Being a real estate professional is much more than just about the hours worked.

Comment 1:  Alert readers might query why §469(i) did not at least let the Drocellas use $25,000 of their losses against active income.  After all, §469(i) permits taxpayers who are not qualified real estate professionals to still offset up to $25,000 of losses from their rental activities as long as they have “actively participated” in the rental.  §469(i)(1).  That’s a pretty low bar and from the facts here it seems the Drocellas would meet that requirement.  However, other alert readers will see that $25,000 deduction is totally lost when AGI exceeds $150,000.  Here, the Drocellas had reported an AGI of over $160,000, which not only was more than the $150,000 but also reflected their claimed $63,000 loss.  See the 2018 Form 1040 (remember that one?), which told taxpayers to reported Schedule E income or loss on Schedule 1 and then calculate AGI based on that.

Comment 2:  Readers, help me out!  I don’t see how taxpayers who meet the Hours Worked test would ever have difficulty showing material participation in their real property trade or business.  That is because while the statute is quite vague on what constitutes material participation (it must be “regular,” “continuous,” and “substantial”), the regulations give some nice bright lines.  In particular, Treas. Reg. 1.469-5T(a)(1) says a taxpayer will be treated as materially participating in an activity if the taxpayer “participates in the activity for more than 500 hours” during the tax year.

Remember a taxpayer has to perform more than 750 hours of services to meet the Hours Worked test.  That would seem to mean they would always meet the regulation’s material participation requirement.  However, I caution that I am no expert in this area and so I welcome any comments correcting my impression.  It’s not important for today’s lesson, but I’m always happy to be told I’m wrong.  It’s how one learns.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.