Powered by Google

Search form

Fowler v. Comm'r: Real Estate Investor Cannot Avoid Passive-Activity Loss Rules

The Tax Court has recently considered a business owner's challenge to an Internal Revenue Service ("IRS") determination that the business owner did not qualify as a real estate professional under the Internal Revenue Code ("Code") provisions regarding passive activity losses.

William C. Fowler ("Taxpayer") was the owner of a heating/air conditioning business ("Company") as well as four rental properties. His wife was an employee of the Company and also assisted in the management of the rental properties that were located throughout the east coast. The Taxpayer estimated that he spent 664 hours in 1994 and 712.5 hours in 1995 working for the Company. He also estimated that he spent 1,555 hours in 1994 and 1,052 involved in the management of the rental properties. Included in his estimates were the time he spent traveling to each property. His wife estimated that she spent 600 hours a year performing administrative tasks in support of the rental activities. During 1994-95, one of the properties was essentially vacant over the entire period, causing the Fowlers to lose money on their real estate portfolio for those two years.

Based on the time spent by the Fowlers managing their real estate properties and because the Company's activities were related to a real estate business or trade, the Taxpayer claimed that he qualified as a real estate professional under the Code's definition and was exempt from the Code's passive-activity loss requirements. Therefore, the Fowlers deducted the losses from the rental properties in 1994 and 1995. The IRS disallowed these deductions, and the Fowlers filed a lawsuit challenging the IRS's decision.

The United States Tax Court ruled in favor of the IRS. The court first considered whether the Taxpayer qualified as a "real estate professional." The Code defines the term within its passive activity loss provisions. A passive activity is any trade or business in which the taxpayer does not materially participate. Passive activity losses are only deductible against passive activity gains. The Code states that rental activity is considered a "per se passive activity," meaning that it does not matter whether the taxpayer materially participates in the rental activity or not because it will automatically be considered a passive activity. An exception to this rule exists for real estate professionals, who can get around the "per se" rule if they demonstrate that they "materially participated" in the rental activity as a trade or business. To qualify as a real estate professional, a taxpayer must show that more than half of the services performed by the taxpayer for that tax year were real estate-related and that the taxpayer spent more than 750 hours providing real estate-related services during the tax year. For a joint return, one of the spouses has to meet the above requirements.

The Taxpayer argued that the time he spent working on his rental properties combined with the time he spent working for the Company, which he argued was a real estate-related trade or business because more than fifty-percent of its revenue came from real estate companies, qualified him as a real estate professional. The court rejected this argument, ruling that the Taxpayer did not qualify as a real estate professional because the Taxpayer did not demonstrate that he had worked over 750 hours providing real estate-related services. The court said that the time the Taxpayer allegedly spent servicing his rental properties was simply work that the Taxpayer was performing as an investor, and such activity is not considered "material participation" in a real estate trade or business. Thus, none of the time the Taxpayer spent servicing the rental properties qualified him as a real estate professional and the "per se" rule applied.

Since the Taxpayer had spent less than 750 hours working on Company-related business in 1994 and 1995, the court did not need to consider whether the time working for the Company qualified the Taxpayer as a real estate professional. The court also questioned the evidence submitted by the Taxpayer in support of his claims, as the court found that the evidence appeared to be mere estimations of the time spent working on the rental properties, which is not sufficient to support a claim of being a real estate professional under the Code. Cases have found that more then a "ballpark guesstimate" is needed to support such claims. Therefore, the court upheld the IRS's determination that the Taxpayer was not entitled to deduct the losses incurred from his rental portfolio in 1994 and 1995.

Fowler v. Comm'r, T.C. Memo 2002-223 (2002).
TO COMPLY WITH CERTAIN U.S. TREASURY REGULATIONS, WE INFORM YOU THAT, UNLESS EXPRESSLY STATED OTHERWISE, ANY U.S. FEDERAL TAX ADVICE CONTAINED IN THE TEXT OF THIS COMMUNICATION, IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY ANY PERSON FOR THE PURPOSE OF AVOIDING ANY PENALTIES THAT MAY BE IMPOSED UNDER THE INTERNAL REVENUE CODE.