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Hakkak v. Commissioner (T.C. Memo. 2020-46)

On April 13, 2020, the Tax Court issued a Memorandum Opinion in the case of Hakkak v. Commissioner (T.C. Memo. 2020-45). The issue properly before the court in Hakkak was whether petitioners are entitled to treat as nonpassive certain rental real estate losses they previously treated as passive under IRC § 469 on their Schedules E (Supplemental Income and Loss) for the years at issue.

The 2011 and 2012 Returns

The petitioners filed a 2011 joint return timely. The return reported (1) “W-2” wages of $100,000 for petitioner-husband (PH) from his law firm, a wholly owned corporation; (2) a business loss of $5,500 (on Schedule C); and (3) net income from rental real estate of $135,000 (on a Schedule E and a Form 8582 (Passive Activity Loss)). PH also reported gross receipts and expenses attributable to PH’s non-personal injury litigation fees, which expenses were higher than the receipts.

On their 2011 Schedule E and 2011 Form 8582 the petitioners reported the income attributable to the firm of $352,000 as net passive income and net losses from PH’s real estate investments in California and Texas totaling $215,000 as allowed passive losses. They also reported prior years’ unallowed passive losses from these entities of $2,000 as allowed passive losses.

On the 2012 joint return the petitioners reported PH’s “W-2” wages from his firm of $48,193, a business loss of $2,000 (Schedule C), “other income” of $18,000 (not otherwise identified), self-employment tax of $1,500, and a student loan interest deduction of $2,500. As before, they attached a Schedule E and a Form 8582 to the 2012 joint return. On Schedule C, the petitioners reported the gross receipts and expenses attributable to PH’s non-personal injury litigation fees; they reported gross receipts of $8,000 and total expenses of $6,000. On their Schedule E and 2012 Form 8582, the petitioners reported the income attributable to the firm of $34,000 and the income attributable to one of PH’s real estate interests (a marina) of $5,000 as net passive income and reported total net losses from the other real estate holdings $39,000 as allowed passive losses.

Audit and Determination

Two real estate entities, JP and CP, caught the eye of the IRS, and it commenced an examination of these entities and the effect that the petitioners’ treatment of gains and losses with respect thereto affected the rest of the returns. PH submitted handwritten calendars to substantiate the hours PH put into both properties.

The calendars (apparently, barely legible themselves) reflected only approximations, and even then, many of the activities were “investor related.” The calendars reflect total time spent in 2011 and 2012 as 1,522 and 755, respectively. PH did not provide time logs or calendars for his two legal practices (personal injury and Schedule C “other” litigation).

A notice of deficiency was issued in May 2015, making various adjustments to the petitioners’ income, including a determination that the passive income attributable to the law firm was nonpassive and could not, therefore, be netted with the reported passive losses from JP and CP (and the other real estate entities) against his ordinary income. All issues were settled, except that the petitioners asked the Tax Court to treat the losses from JP and CP as nonpassive

The taxpayer generally bears the burden of proof in redetermination proceedings. Tax Court Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Segel v. Commissioner, 89 T.C. 816, 842 (1987). This burden requires the taxpayer to demonstrate that the claimed deductions are allowable pursuant to some statutory provision and to substantiate claimed loss deductions by maintaining and producing adequate records. IRC § 6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001). If the taxpayer produces credible evidence with respect to any factual issue relevant to ascertaining his Federal income tax liability and meets certain other requirements, the burden of proof shifts from the taxpayer to the IRS as to that factual issue. IRC § 7491(a)(1); IRC § 7491(a)(2).

The substantiation requirement to shift the burden to the IRS is, well, substantial. The petitioners argued that the burden should surely shift, as they produced over 3,000 pages of documents, 135 exhibits, and conducted a 10-hour trial. What was contained in those 3,000 pages, however, did not satisfy the Tax Court which held that the evidence was not sufficient because the petitioners failed to maintain the requisite records and comply with the requisite substantiation requirements. See IRC § 7491(a)(2)(A); IRC § 7491(a)(2)(B).

IRC § 469 (Losses from Rental Real Estate Activities)

A taxpayer is allowed deductions for certain business and investment expenses under IRC § 162 and IRC § 212. Where a taxpayer is an individual, however, IRC § 469 generally disallows any passive activity loss for the taxable year in which the loss is sustained and treats it as a deduction allocable to the same activity for the next taxable year. IRC § 469(a); IRC § 469(b). A “passive activity loss” is defined as the excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year. IRC § 469(d)(1).

Passive Activities Defined

A passive activity (generally) is an activity involving the conduct of a trade or business in which the taxpayer does not “materially participate.” IRC § 469(c)(1). A taxpayer is treated as materially participating in an activity only if his or her involvement in the operations of the activity is regular, continuous, and substantial. IRC § 469(h)(1). Rental activity is treated as a per se passive activity, regardless of whether the taxpayer materially participates. IRC § 469(c)(2); IRC § 469(c)(4).

Real Estate Professional Exception to General Per Se Passive Activity Rules

Relevant to the Hakkak case, IRC § 469(c)(7) provides an exception to the rule that a rental activity is per se passive. The rental activities of a taxpayer in a real property trade or business who meets certain enumerated requirements (i.e., a “real estate professional”) are not subject to the per se rental activity rule. IRC § 469(c)(7)(A); Treas. Reg. § 1.469-9(b)(6); Treas. Reg. § 1.469-9(c)(1). Instead, the rental activities of a real estate professional are subject to the material participation requirements of IRC § 469(c)(1). Treas. Reg. § 1.469-9(e)(1).

A taxpayer qualifies as a real estate professional if: (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which he materially participates. IRC § 469(c)(7)(B)(i); IRC § 469(c)(7)(B)(ii).

Establishing Hours of Participation

A taxpayer may establish hours of participation in a real property trade or business by any reasonable means. Treas. Reg. § 1.469-5T(f)(4). However, “reasonable” is in the eye of the beholder, and, in the Tax Court’s eyes, “reasonable” is a very high standard, indeed. See, e.g., Moss v. Commissioner, 135 T.C. 365, 369 (2010); Antonyshyn v. Commissioner, T.C. Memo. 2018-169; Lum v. Commissioner, T.C. Memo. 2012-103; Estate of Stangeland v. Commissioner, T.C. Memo. 2010-185. Contemporaneous daily reports are not required, unless the taxpayer is unable to establish participation by other reasonable means. Id.

Reasonable means includes appointment books, calendars, or narrative summaries each of which must readily identify the services performed and the “approximate” number of hours spent performing such services. Treas. Reg. § 1.469-5T(f)(4). However, the Tax Court has noted previously that it is not required to (read: will not) accept a post-event “ballpark guesstimate” or the unverified, undocumented testimony of taxpayers. Moss, 135 T.C. 365 at 369; Antonyshyn, T.C. Memo. 2018-169; Lum, T.C. Memo. 2012-103; Estate of Stangeland, T.C. Memo. 2010-185.

Non-Acceptance of Self-Serving Testimony

The Tax Court agreed to set its doubt and disbelief aside for a moment and assumed that JP and CP constituted real property trade or businesses and that PH materially participated in JP and CP. Even with these assumptions, however, the Tax Court found that the petitioners failed to establish that PH met the one-half personal service hours requirement and the 750-hour requirement.

The Tax Court opined that, even assuming that the evidence and testimony presented established the satisfaction of the hour tests, the Tax Court found that PH’s activities were largely “more akin” to those of an investor than a real estate professional, and, thus did not count towards the hours requirements. See Antonyshyn, T.C Memo. 2018-169 at *10; Barniskis v. Commissioner, T.C. Memo. 1999-258, *11-12; Treas. Reg. § 1.469-5T(f)(2)(ii).  The Tax Court also was rather adamant, as it has been in the past, that it is loath to accept self-serving, uncorroborated testimony from a taxpayer. Shea v. Commissioner, 112 T.C. 183, 189 (1999); Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Original opinion: (T.C. Memo. 2020-46) Hakkak v. Commissioner

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