In order to qualify as a real estate professional in the eyes of the IRS, the taxpayer has to prove that he or she spent 750 hours in the real estate profession. This can be verified in many different ways, but the cleanest way is through contemporaneous records. However, holding a full-time job has always been a deterrent to most taxpayers proving this amount of time being spent on real estate.
But in the recent case of Mohammad M. Zarrinnegar, et ux. v. Commissioner, TC Memo 2017-34, the US Tax Court found that a dentist also qualified as a real estate professional and, therefore, was able to deduct losses from real estate.
The facts of the case are as follows: Dr. Mohammad Zarrinnegar and his wife, Dr. Mary Dini, are dentists and own their own practice. During the years at issue, 2010 to 2012, they worked at their dental practice in shifts. Dini worked Mondays, Wednesdays, Thursdays, and Fridays from 9 a.m. until 2:30 p.m., and some Saturdays from 8 a.m. until noon. Zarrinnegar worked at the dental practice Mondays, Wednesdays, Thursdays, and Fridays from 2:30 to 6 p.m.
During the time frame in question, the couple also owned a real estate business. It consisted of Zarrinnegar’s real estate brokerage activity and four rental properties that the couple owned and Zarrinnegar managed. Dini did not participate in the real estate business.
Zarrinnegar spent hundreds of hours on brokerage-related activities, including brokers’ tours, listing searches, open houses, property viewings, and client meetings. He also spent significant time each year managing the couple’s four rental properties. All told, he spent more than 1,000 hours on the real estate business during each year at issue.
On Schedules E, Supplemental Income and Loss, attached to their tax returns, the couple reported losses from their real estate business of $221,582 for 2010, $242,276 for 2011, and $220,788 for 2012.
The IRS argued that Code Section 469(a) requires disallowance of their claimed deductions for losses from the real estate business. The IRS did not contest the existence or amounts of the losses or argue that the claimed deductions are disallowed or limited by any other provision or principle of law.
The Internal Revenue Code generally disallows a deduction for losses from passive activities of individuals and certain entities, but allows such losses to be carried over and treated as a deduction allocable to such activity in the next taxable year (Section 469(a) and (b)).
A passive activity is a trade or business in which the taxpayer does not materially participate (Section 469(c)(1)). Material participation is regular, continuous, and substantial involvement in business operations (Section 469(h)(1)).
The Tax Court stated:
As a general rule, rental activities are per se passive whether or not the taxpayer materially participates. Section 469(c)(2). As an exception, however, rental activities of taxpayers in real property trades or businesses (real estate professionals) are not treated as passive if the material participation requirement is satisfied. Section 469(c)(7).
Under Section 469(c)(7)(B) a taxpayer is a real estate professional if:
(i) More than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
(ii) Such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
In the case of a joint return, these requirements are met if and only if either spouse separately satisfies them. Because petitioner wife did not participate in the real estate business, we consider whether petitioner husband's activities satisfy this test.
A taxpayer’s material participation is determined separately with respect to each rental property unless the taxpayer makes an election to treat all interests in rental real estate as a single rental real estate activity (Section 469(c)(7)(A); Section 1.469-9(e)(1), Income Tax Regulations). The couple acknowledged that they made no such election.
A taxpayer can satisfy the material participation requirement if the individual meets any one of seven tests, including the following: “The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.” (Section 1.469-5T(a), Temporary Income Tax Regulations)
The IRS conceded that Zarrinnegar’s participation in each of his real estate activities, for each year at issue, constitutes substantially all of the participation in each activity of all individuals. Therefore, the material participation element of the real estate professional test was ruled to have been met.
This left the elements of the real estate professional test that Zarrinnegar needed to meet.
They included:
Whether more than one-half of the personal services performed in trades or businesses by Zarrinnegar during each year at issue were performed in real property trades or businesses.
Whether Zarrinnegar performed more than 750 hours of services during each year at issue in real property trades or businesses.
Because Zarrinnegar worked fewer than 1,000 hours per year at the dental practice and more than 1,000 hours per year at the real estate business, both of these elements were met.
Section 1.469-5T(f)(4), Temporary Income Tax Regs, 53 Fed. Reg. 5727, says:
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
To establish the number of hours Zarrinnegar spent each year on his real estate business, the couple offered his testimony and logs of hours for 2010, 2011, and 2012. Each log showed that Zarrinnegar spent more than 1,000 hours per year on his real estate activities.
He testified that the logs had been prepared contemporaneously. He also testified about the logs’ contents and was able to recall extensive details relating to the entries. The couple also offered the testimony of several other witnesses, including Dini’s. The court found that Zarrinnegar worked more than 1,000 hours per year at the real estate business.
Therefore, the court concluded that Zarrinnegar’s participation in real estate activities for 2010, 2011, and 2012 met the test in Section 469(c)(7)(B), and the court did not disallow the couple’s deductions for losses from rental properties.