Friday, May 27, 2011

To Keep Your Story Straight You Need to Know What it Needs to Be

Yusufu Y. Anyika, et ux. v. Commissioner, TC Memo 2011-69

After the introduction of the at-risk rules, real estate was the last real tax shelter.  Then came the passive activity loss rules.  The passive activity loss rules (Code Section 469) require us to put our trade our business activities (including interest in flow through entities) into buckets.  Losses in the passive bucket can only be used to the extent of gains in the passive bucket (It is not an "offset".  Passive capital gains release passive ordinary losses.  So sometimes a gain can reduce your liability.)  Losses that are not used are carried forward and are attached to the activity that generated them.  They are released when the activity is fully disposed of even if there is no passive income in that year. 

Activities are classed as passive based on how much you participate in them.  Their are a number of ways to meet the "material participation" standard.  The simplest is 500 hours per year.  "Rental activities" are special.  They are deemed to be passive regardless of how much time you spend on them.  There is an exception to that rule.  Rental losses are not "per se" passive to people engaged in real estate trade or businesses.  The magic number here is 750 hours:

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.

Sometimes people miss that "materially participates" part of the requirement.  In order for the exception to work for many people, they need to make an election to aggregate all their real estate activities for purposes of measuring material participation. Otherwise somebody with five properties might not be considered to be materially participating in any of them.

Now the 750 hours is not the whole story as Mr. Anyika discovered a bit late in the game.  Here is his situation:

Petitioners, Yusufu Yerodin Anyika (Mr. Anyika) and Cecelia Francis-Anyika (Mrs. Francis-Anyika), are married and filed joint returns for tax years 2005 and 2006. Mr. Anyika is employed as an engineer, and he works 37.5 hours per week, 48 weeks per year. Mrs. Francis-Anyika is employed as a nurse, and she works 24 hours per week.


Mr. Anyika has been purchasing, renovating, managing, and selling rental properties since the 1990s. He views his rental real estate activity as a second job and as an investment. During 2005 and 2006, Mr. Anyika owned two rental properties.

Mr. Anyika spent a good bit of time on the properties and thought he should qualify for the real estate trade or business exception.  He explained this in his petition and at trial:

 In their petition and at trial, petitioners contended that Mr. Anyika qualified as a real estate professional because he had spent at least 750 hours actively managing the rental properties. On Form 4564, Information Document Request, submitted by petitioners during their audit, petitioners declared, under penalty of perjury, that Mr. Anyika devoted 800 hours per year to working on the rental properties during 2005 and 2006.

With that nice fifty hour cushion he thought he was all set. Unfortunately 750 hours is not the only requirement.  Here is the other requirement:

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

Mr. Anyika also worked full time as an engineer which took up substantially more than 800 hours per year.  He tried to salvage the situation:

It was only after the Court had explained the law that Mr. Anyika understood, for the first time, that he would have to have spent at least 1,800 hours engaged in the real estate business in order to qualify as a real estate professional under section 469(c)(7)(B). After understanding that, to qualify, he had to spend more hours engaged in managing the rental properties than he did working as an engineer, Mr. Anyika began to contend that he had spent the equivalent of 8 hours per day, 5 days per week, 48 weeks per year (1,920 hours per year) working on the rental properties. After being confronted during trial by the evidence of his prior signed statement that he worked 800 hours per year on the rental properties, Mr. Anyika stated that he was “speaking from memory with the exact numbers”, and that to be sure, he would need to look over the numbers more closely.

The Court did not find him credible:

We do not find Mr. Anyika's testimony that he worked approximately 1,920 hours per year on the rental properties credible. Not only does it contradict his earlier signed statement, but it also changed during trial once Mr. Anyika realized that he would need to have devoted more hours to his real estate properties than to his job as an engineer (i.e., he would need to have spent more than 1,800 hours working on the rental properties), instead of the 750 hours he had originally believed would be sufficient for him to qualify as a real estate professional under section 469(c)(7).

When it came to the penalties taxpayers tried the classic "Turbo Tax made me do it" defense.  The Court, using more measured if less colorful language, gave the old data processing answer to the Turbo Tax defense - Garbage in, Garbage Out.  Their has been much talk, of late, of what the qualifications of people who prepare tax returns should be.  Their will be special exams with members of some professions such as CPA's exempt from taking then.  Based mainly on reading tax court decisions, I think members of some professions should be required to take a special exam before they are allowed to prepare their own returns specifically engineers and attorneys.  Nobody ever listens to me, though.

5 comments:

  1. Peter - thanks for the detailed analysis of this case. What level of understanding of the tax law is appropriate for preparing a return? The IRS will soon have almost all paid preparers who are not CPAs, Enrolled Agents or attorneys taking exam. You suggest that perhaps even self-prepared should take an exam as well. Something to consider ...

    One more item the court said in the Anyika case was - "A reasonable person in Mr. Anyika's position, understanding that the tax law governing the deductions he claimed was complex, would have consulted a tax professional instead of merely assuming that he qualified on the basis of his own conclusions."

    It is interesting that the court did not say that a reasonable person should have consulted IRS publications and form instructions. If this wasn't mentioned because the judge knows it would not be enough to figure out the law, should the IRS be placing warnings on publications and forms that individuals are advised to consult with a paid return preparer?

    Thanks for the great blogging!

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  2. Thanks for the kind words. I'm not letting your off the hook though on getting a guest post from you some time. The thing about exams to prepare your own return was actually a bit of a joke. Not a scientific sample but it seems you do see a disproportionate amount of self preparing engineers and lawyers in tax court. Not sure what it is with engineers, but I'm pretty sure trial attorneys consider their tax return to be a first offer.

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  3. Peter,

    Based on the above referenced case, which implied that had the petitioner owned more the 5% he would have qualified as a real estate professional under 469; are engineers who provided engineering services in the real property construction industry engaged in a real property trade or business? I.e. could a more than 5% S-corp owner of an engineering firm (working in the real property development industry) qualify as engaged in a real property trade or business and elect to be a professional, therefore being able to deduct rental loses from other activities. I’m hung up on the requirement to have more than 50% of personal services in a real estate business and whether a taxpayer’s engineering services qualify as a real estate business.

    Your perspective would be greatly appreciated.

    Justin

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  4. I think you have a decent argument for an engineer involved in real estate development. I couldn't find anything specific though.

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  5. Thanks for looking! The case you referenced in this blog was the only thing I could find that specifically addressed the question, but in a non-direct way. I’m planning to give my research and this case to the taxpayer and have him make the decision.
    Best,
    Justin

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