Guillermo Merino Jr., et ux. V. Commissioner, TC Memo 2013-167
Recently, the U.S. Tax Court concluded that a taxpayer didn’t qualify as a real estate professional, thus limiting his ability to deduct passive rental real estate losses. The taxpayer attempted to deduct rental real estate losses stemming from seven rental properties for the 2007 tax year. The Tax Court found that the taxpayer did not meet the tests established in Internal Revenue Code (“IRC”) Section 469(c)(7) to qualify as a real estate professional (“REP”). Thus the rental losses were re-characterized as losses from passive activities and not currently deductible.
Guillermo Merino, Jr., (“Merino”) was the president and sole shareholder of One Stop Home Loans ("One Stop"), an S corporation in 2007. A typical day at One Stop for Mr. Merino consisted of supervising between two and four employees, making calls, bringing borrowers or potential borrowers into the office, and reviewing and processing files and loans.
Merino also owned seven properties in Colorado and Nevada, which generated losses that were reported on Schedule E. Along with his mortgage business, and real estate rental activities, Merino operated a distribution business that was reported on Form 1040, Schedule C. Merino’s tax return reported losses from all seven rental properties, which were subsequently disallowed by the IRS.
The general rule in Section 469 is that rental real estate activities are treated as passive activities, thus limiting the ability for a taxpayer to currently deduct rental losses except to offset income from passive activities. However, Section 469(c)(7) carves out an exception for certain rental real estate activities where the taxpayer qualifies as a REP. Generally, a taxpayer will be a REP if:
(i) More than one-half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses, and
(ii) The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses.
A REP’s rental real estate activities can be non-passive if the taxpayer “materially participates” in the rental activity. Generally, this requires over 500 hours of services in the operation of the activity. A REP can also elect to have all rental real estate activities combined as one activity to satisfy the “material participation test.”
The Tax Court Decision
The Tax Court concluded that Mr. Merino did not have sufficient evidence to prove he qualified as a real estate professional because he couldn’t establish that real estate services were greater than 50% of all services performed by Merino. The Court expressed that Merino failed to present evidence of the time spent on non-real estate services; thus, he failed to meet the first requirement of Section 469(c)(7).
Further, the Court found that Merino failed to carry the burden of proof with respect to the 750 hours test. Merino attempted to prove his time spent on rental activities by preparing a summary schedule using estimates and his memory. The Court found Merino’s summary to be less of an approximation and more of a “ballpark guesstimate.” The Court said that a taxpayer may use methods, including but not limited to, “the identification of services performed over a period of time and the approximate number of hours spent based on appointment books, calendars, or narrative summaries." Merino’s summary of hours was found to be insufficient to substantiate the 750 hours requirement.
The Tax Warrior Perspective
The Tax Court decision highlights the need for taxpayers claiming REP status to keep contemporaneous records. Furthermore, taxpayers should not lose sight of the first requirement of Section 469(c)(7), stating that more than one-half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses.
There was no mention in the case of Merino’s “home loan” business being treated as a “real property, trade or business.” Perhaps this could have been presented as an alternative argument for Merino to be a REP.
The Merino case demonstrates that simply owning property, no matter how many units, does not necessarily allow you to take the loss deduction. You should speak to your tax advisor about how you are positioned to take advantage of deductions should your rental properties take a loss.
The Tax Warriors®at Drucker & Scaccetti have extensive experience in representing individuals who own real estate and operate in the real estate industry. We are able to help you navigate this section of the IRC to make you as tax efficient as possible. Contact us via the “Ask A Tax Warrior” button below if you have any questions about your specific situation. We are always prepared to help you with this or any other tax matter related to real estate ownership.