Friday, March 18, 2011

Miss Is As Good As a MIle

Todd D. Bailey, Jr., et ux. v. Commissioner, TC Summary Opinion 2011-22

Quite a few cases about the passive activity loss rules show up in tax court.  Frequently, the taxpayers seem a bit lame.  There was the fellow who wanted to count the time that he was "on call" for his tenants.  Also, the have to put up with their time estimates being considered "ballpark guesstimates", a robust term who's use in tax law seems to be limited to passive activity cases.  The case of Pamela Bailey (she is the ux.) has none of that.  Although I see the inexorable logic of the tax court, I think she got rather a raw deal.

The passive activity loss rules (Section 469) was the Tax Reform Act of 1986's knock-out blow to tax shelters as we used to know them.  The rules require us to put our trade or business activities into various buckets.  Losses within the "passive activity" bucket can only be used to the the extent there is gain in the passive bucket (Note.  Some people say "offset", which can lead to error.  A capital gain in the passive bucket is still a capital gain).  There is a significant amount of complexity to the rules, which I will run roughshod over in discussing this case.  A passive activity under these rules (The term is used in other areas, like S Corporations, and has different meanings.) is a trade or business in which the taxpayer does not materially participate.  There are a variety of ways to meet that standard, but the one that is relevant here is 500 hours in a year.  Then there are rental activities.  Rental activities are per se passive.  If you own rental property, please don't yell at me.  I know it can be a lot of work.  This is the tax law.  It is what it is. Deal with it.

There is an exception to the per se passive rule for rental activities.  People in real estate trades or businesses can treat rental activities like other businesses.  There are a number of requirements, but the critical one for this case is 750 hours engaged in real estate activities. 

Todd Bailey was an emergency room physician.  He is one of the types of people I think about whenever I think I have stress.  At any rate Dr. Bailey doesn't really enter into the case other than producing wages of $212,200 that might have been sheltered by real estate losses.

It was Mrs. Bailey who was handling the real estate.  She had qualifications:

Petitioner's father was a builder. Her mother worked with her father as a bookkeeper and an interior decorator. This upbringing gave petitioner an “eye” for the housing market, and experience with building codes, architectural plans, and subcontractors. Beginning around 1980 and using mortgage financing and joint funds with petitioner husband, petitioner continuously was in the market to purchase property with potential for either resale or conversion into income- producing property.

She had four properties :

1. The Inn on Alisal Road

One of petitioners' rental properties was on Alisal Road, about 6 or 7 miles from the couple's home. They purchased the property in 2000. The structures consisted of a 1,200-square- foot, two-bedroom, 3/4-bath (no tub) front house, built in 1949 or 1950, and a smaller back unit that had been converted from a one-car garage into a separate residential dwelling.

Petitioner named this combined property “The Inn on Alisal Road” (Inn). As the name indicates, petitioner furnished the two units and offered them together or separately for short-term rent to overnight lodgers, usually for about 3 days at a time.

2. The Second Street Property

....... second of petitioners' rental properties was on Second Street (Second Street property), about two blocks from the Inn. Petitioners purchased the property in 2000 for $292,000. Similar to the Inn, the property included two structures. The front unit was a 1,149-square-foot, three-bedroom home, with 1-3/4 baths. The back unit was a one-car garage that petitioner converted in 2002 into a small residence with a three-quarter bath and a kitchenette.

This one turned out to be a classic property from hell.  It could stand as a warning to those who see late night commercials promising that by adopting certain secret methods you can make a small fortune in real estate with no capital and little work :

By late 2000 petitioner's tenants in the front house noticed a mildew problem. The tenants moved out. They turned out to be petitioner's last tenants in the front unit. As petitioner began stripping away layers of linoleum to determine the extent of the mildew problem, she discovered that black mold was present throughout the entire underpinning of the home. By the end of 2001 petitioner was “at wits' end”. She eventually discovered that an earlier inspector had determined that the home has insufficient subvents. In addition, a prior owner built an addition that blocked some of the existing subvents. Further, the El Nino storm of 1997-98 soaked the carpets, flooring, and walls, compounding the problem. The toxic mold infestation was so bad that petitioner was unable to provide a warranty of habitability to any prospective tenant.

The type of real estate endeavors that Mrs. Bailey engaged in are probably one of the best ways that someone with little to start with can become fairly prosperous.  It is by no means a sure thing, though.  The requirement to be absolutely certain that you will make a small fortune in real estate is the same as in any other endeavor.  Start with a large fortune.

3. Boise Property

The third of petitioners' rental properties was on Rose Hill Street, Boise, Idaho (existing Boise property). Petitioner became interested in Boise because she found that she liked the area from visiting a brother living there and a great uncle who lived nearby. The record is sparse about this property, other than that it was a single-family home that petitioner purchased in an earlier year and which one tenant or family rented for all of 2004.

4. New Acquisition in Boise

On August 25, 2004, petitioner paid $185,000 to acquire another one-story single-family home in Boise, on a 3/4-acre lot, also located on Rose Hill Drive (new acquisition in Boise). She financed the purchase with a $166,315 mortgage and joint funds. The house, built in 1941, is a “darling” home with a wood burning fireplace, crown molding, and a brick exterior made with “clinker bricks”. The main floor contains two bedrooms, one bathroom, and a small kitchen. Prior owners had converted the basement into an apartment for a person who took care of the owner. Petitioner did not begin renting the home to tenants in 2004.

Mrs. Bailey kept good track of her time and the IRS found her to be credible - no "ballpark guestimator".  Time spent on real estate was as follows :
The Inn on Alisal Road                324
The Second Street property         358
The existing Boise property           24
The new acquisition in Boise        105
Researching potential acquisitions 192
Grand total for all properties      1,003

There was no issue raised about her not electing to aggregate.  So she should be fine.  Not so fast.  The Inn on Alisal Road had rentals for, on average, three day periods.  So it was not a "per se" passive rental activity.  It was a non real estate trade or business reported on Schedule C.  When those hours are kicked out she ends up with a total of 679 hours in real estate activities.  Close to 750 hours, but the 750 is a "bright line" test.  There are areas besides horseshoes and hand grenades where almost can count, but this is not one of them.

Mrs. Bailey did not get hosed quite as badly as she might have.  Note that the 324 hours on the Inn is less than 500, which could make it a trade or business in which she did not materially participate.  Fortunately she met an alternative test, probably that she put in more time than anybody else did on the activity.  Of course if the Inn had been profitable, that would have hurt her.

All in all, this case covers a good bid of ground that would be of interest to landlords and their advisors. 

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