On September 29, 2020, the Tax Court issued a Memorandum Opinion in the case of Lucero v. Commissioner (T.C. Memo. 2020-136). The issue before the court in Lucero v. Commissioner was whether the petitioners’ real estate loss deductions were disallowed by IRC § 469 and/or IRC § 280A.
Background to Lucero v. Commissioner
The petitioner-husband owned a short-term rental property in The Sea Ranch, California. To be clear, the property was not in Sea Ranch, mind you, but The Sea Ranch…lest there be any confusion with the rabble and riff-raff in Sea Ranch, California. He rented the property to tenants for 146 nonconsecutive days in 2014 and 152 nonconsecutive days in 2015. The petitioners paid a property management company to manage the property’s day-to-day rental operations, which included advertising to prospective tenants, collecting deposit fees and rent, maintaining and cleaning the property between stays, landscaping, assisting the petitioners in hiring repair subcontractors, and responding to tenants’ comments and complaints. The petitioner-husband controlled certain administrative decisions, such as setting rental rates approving expenses over $100, and not renting to said riff-raff.
The petitioners perform some upkeep on the property, which were likely simply reconnaissance missions to make sure that the unspeakables were kept far afield from The Sea Ranch. Notwithstanding the questionable motives, the petitioner-husband drove to the property approximately 6 to 9 times a year for various tasks like landscaping, inventorying, and overseeing necessary repairs. Some trips required the petitioners to stay multiple nights at the property, and they spent one week during Christmas each year in The Sea Ranch.
Not unsurprisingly, the petitioners did not keep any contemporaneous logs, calendars, or other documentation stating the number of hours they spent on activities related to the property for the years in issue. Rather, the petitioner-husband created a log while the case was with Appeals that attempted to reconstruct, using invoices and receipts, the number of hours petitioners spent on these activities. He estimated that the petitioners spent approximately 270 hours on activities for the property in 2014 and 2015. The petitioner’s report of the loss of $18,000 in 2014 and $24,000 in 2015. The notice of deficiency disallowed any deduction for the Schedule E real estate loss for each year.
The Sea Ranch as a Residence / Vacation Home
The IRS argued that petitioners used the Sea Ranch property as a residence and a vacation rental for purposes of IRC § 280A rather than as a residential or business rental property and, thus, are not entitled to deduct their rental real estate losses related to the property. A dwelling unit is considered to be a taxpayer’s residence if its use for personal purposes exceeds the greater of 14 days or 10% of the days the unit is rented at a fair rental value in a taxable year. IRC § 280A(d)(1).
A taxpayer is deemed to have used a dwelling unit for personal purposes when, for any part of a day, the taxpayer or any member of the taxpayer’s family uses the unit for personal purposes or any individual uses the unit unless a fair rent is charged for the use. IRC § 280A(d)(2)(A), (C). Days spent primarily repairing and maintaining the unit will not count toward personal use merely because other individuals on the premises are engaged in some other activity. IRC § 280A(d)(2); see also Rose v. Commissioner, T.C. Memo. 2019-73, *24-*25; Van Malssen v. Commissioner, T.C. Memo. 2014-236, *14-*15 (discussing the history of IRC § 280A(d)(2)).
Although the taxpayer generally bears the burden of proof to establish a deduction, Welch v. Helvering, 290 U.S. 111, 115 (1933), if, the IRS presents a new theory in addition to that which was presented in a notice of deficiency, the burden shifts to the IRS if the new theory either alters the original deficiency or requires the presentation of different evidence. Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989); see also Shea v. Commissioner, 112 T.C. 183, 191-197 (1999). The IRS did not argue that IRC § 280A precluded the petitioners’ real estate losses until trial. Although the Tax Court ultimately did not determine whether the IRS’s arguments required the presentation of different evidence, deciding the case pursuant to IRC § 469, the Tax Court “assumed” that the burden had shifted to the IRS with respect to IRC § 280A, and that the IRS had not met such burden.
Passive Loss Limitation
A passive activity is any activity involving the conduct of a trade, business, or income-producing activity, in which a taxpayer does not “materially participate.” IRC § 469(c)(1), (6). A taxpayer’s deductible loss from passive activities in a taxable year is limited to the taxpayer’s income from passive activities. IRC § 469(d)(1). Any loss from exceeding the income from those passive activities constitutes a “passive activity loss,” and any deduction arising therefrom is disallowed for that taxable year. However, such passive activity loss may be carried over to the next taxable year to offset passive activity income for that next year, if any. IRC § 469(a), (b), (d)(1); Treas. Reg. § 1.469-2T(b)(1).
The petitioners’ operation of the property will be considered a trade or business under IRC § 469(c)(6) and a passive activity under IRC § 469(c)(1), unless the petitioners can establish that they materially participated in the activity during the years in issue. See Bailey v. Commissioner, T.C. Memo. 2001-296, *7-*9. It should be noted that rental activity is generally passive, regardless of whether the taxpayers materially participate in the activity. See IRC § 469(c)(2), (4); Bailey, T.C. Memo. 2001-296, at *3; Treas. Reg. § 1.469-1T(e)(1)(ii). (There are special rules for “real estate professionals” under IRC § 469(c)(7), but neither side raised this issue.) In activity that involves the use of tangible property is not rental activity if the average period of customer use for such property is seven days or less in a taxable year, i.e., a “short-term” rental. Treas. Reg. § 1.469-1T(e)(3)(ii)(A). Because the property was used for short-term rentals in 2014 and 2015, the petitioner’s’ short-term rental activities were not, technically, rental activities under IRC § 469.
Short-Term Rental Activities not Technically Rental Activities
Because short-term rental activities are not actually rental activities under the logic of the Code (which logic only a tax attorney or sitting President can love), the test turns back to whether the taxpayer materially participated in the short-term rental activities. Material participation requires that a taxpayer, whose activities are grouped with the taxpayer’s spouse for purposes of the material participation test, must be involved in the activity on a regular, continuous, and substantial basis. IRC § 469(h)(1) (general test); IRC § 469(h)(5) (spousal attribution).
A taxpayer is considered to have materially participated in an activity if he satisfies any one of seven regulatory tests. Treas. Reg. § 1.469-5T(a). He may establish hours of material participation by any reasonable means. Treas. Reg. § 1.469-5T(f)(4). Contemporaneous reports, logs, or similar documentation are not required if the taxpayer can establish his qualification by other reasonable means. Id. Although post event “ballpark guesstimates” of hours will not suffice, a taxpayer may use appointment books, calendars, or narrative summaries as such “reasonable means” to identify services performed over a period of time and approximate time spent performing those services. Id.; Moss v. Commissioner, 135 T.C. 365, 369 (2010); see, e.g., Balocco v. Commissioner, T.C. Memo. 2018-108, *21.
The 100 Hours Test for Material Participation
One such regulatory test requires that individual participate in the activity more than 100 hours during the taxable year, so long as that individual’s participation in the activity was not less than the participation of any other individual for the year. Treas. Reg. § 1.469-5T(a)(3). Notwithstanding this, work performed by an individual in his “capacity as an investor” in an activity is not be treated as participation in the activity unless the individual is directly involved in the day-to-day management or operations of the activity. Treas. Reg. § 1.469-5T(f)(2)(A). The petitioners were, unquestionably, not involved in the day-to-day management or operations of the property, because they had hired a property manager to do just that.
Paying bills, coordinating with the property manager, and preparing tax returns constitute investor activities that do not count towards the 100-hour requirement. Barniskis v. Commissioner, T.C. Memo. 1999-258, *5. Further, the petitioners bear the expense of commuting, because it is a personal expense unless an allocation for additional expenses can be made between personal and business expenses. Ellison v. Commissioner, T.C. Memo. 2017-134, *14, n.6 (citing Fausner v. Commissioner, 413 U.S. 838, 839 (1973)); see also Commissioner v. Flowers, 326 U.S. 465, 473 (1946); Treas. Reg. § 1.262-1(b)(5).
Showing a Pinch of Snark
At this point, the Tax Court gets a little punchy, which as you know, dear reader, is what you were beleaguered author lives for. The Tax Court notes that the petitioners’ logs, prepared well after the actual trips to Bed Bath & Beyond and Gualala Supermarket, seemed to the Tax Court a skosh “excessive.” Why excessive, you may ask. The petitioner stated that they spent two hours shopping for coffee filters at Bed Bath & Beyond and one hour shopping for garbage bags and facial tissue at Gualala Supermarket. Putting aside for a minute the fact that these logs are likely patently fabricated, one has to wonder whether the petitioners (a) were the single most indecisive couple in the history of coupledom, (b) were avid recyclers who bore down on an unsuspecting clerk as he stacked said coffee filters to ask whether the particular filters that they had selected were 100% biodegradable and 200% dolphin and tuna friendly, (c) were extreme couponers, or (c) were playing the single worst round of Supermarket Sweep ever seen in its esteemed history. Sadly, the Tax Court does not fully investigate the two-hour coffee filter run, finding instead that it was simply “excessive” and moving on.
Unreliability of Logs and Failure to Produce “Evidence” Fatal
Because of the “excessive” entries and largely combined personal-and-rental purposes of each entry, the Tax Court found that the logs were not reliable, in and of themselves, and was not, therefore, a reasonable means of establishing material participation. Rose v. Commissioner, T.C. Memo. 2019-73, *29. Notwithstanding the Tax Court calling bullshit on the petitioners’ after-created logs, the Tax Court notes that even if it were to assume that the petitioners spent 100 hours on short-term rental activities during 2014 and 2015, they failed to include any documents on the record that showed the number of hours that other individuals, such as the management company, spent on those activities in connection with the property. Treas. Reg. § 1.469-5T(a)(3). As such, the petitioners failed to show that the petitioners’ participation in short-term-rental activities exceeded the participation of any other individuals in either of the years in issue. See Hoskins v. Commissioner, T.C. Memo. 2013-36, *14; Akers v. Commissioner, T.C. Memo. 2010-85, *3-*4.
Accordingly, the petitioners’ real estate losses were passive activity losses for purposes of IRC § 469, and the Tax Court sustained the IRS’s disallowance of the petitioners’ real estate loss deductions for both years in issue.
(T.C. Memo. 2020-136) Lucero v. Commissioner
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