John Kutney, an aeronautical engineer and consultant owned several rental properties including two apartment complexes. He claimed losses totaling over $130K in 2005 through 2007. John didn’t keep a record of the time he spent or indicate on his tax forms that he was claiming to be a real estate professional. On audit, the IRS disallowed his tax deductions.
The problem is that rental activity is automatically considered a “passive activity,” which means you cannot deduct the losses unless you have income from similar passive activities. This trap catches many taxpayers with rental properties and no other profitable passive business investments.
The exception John was hoping to use on audit, is for Real Estate Professionals. However to meet that standard he must spend over 750 hours in real property trades or businesses and those hours must be more than half of the personal services he performs during the year.
Although John attempted to convince the IRS and the Tax Court that he meet those requirements, they didn’t buy his arguments. In particular, like many taxpayers before him, he claimed that being on call 24/7 with regard to his rental properties accounted for an overwhelming number of hours. The Court didn’t agree that simply being on call met the standard and John was denied deductions for the losses.
Rental property can be an important part of your wealth accumulation strategy. Just don’t expect to use these investments to reduce your tax bill without determining if you meet an exception to the general rules. A quality tax adviser can help you determine how your rental property will be treated before you execute such a strategy.
Kutney, TC Summary Opinion 2012-120