Sometimes I read a tax case and ask myself “why did the IRS chase this?”
Lewis is one of those cases.
Let’s explain the context to understand what the IRS was after.
It will soon be three decades that Congress gave us the “passive activity” (PAL) rules. A PAL is a trade or business that you do not sufficiently participate in – that is, you are “passive” in the business. This means more when you have losses from the activity, as income is going to be taxed in any event. It was Congress’ intention to take the legs out from the tax shelters, and with PALs they have been largely successful.
The PAL rules got off to a rocky start. One of the early problems was Congress’ decision to classify real estate activities as passive activities. Now, that concept may make sense if one own a duplex a few streets over, but it doesn’t work so well if one is a home builder or property manager.
Say, for example, that a developer builds a hundred condo units. The real estate market reverses, and he/she cannot sell them as quickly as planned. The developer rents the units, waiting for the market to improve.
Most of us would see one activity. Congress saw two, as the rental had to be segregated. There was no harm if both were profitable. There was harm if only the development was profitable, however, as the rental loss would just hang in space until there was rental income to absorb it.
That was the point of the passive activity rules – to disallow the use of passive losses against nonpassive income.
Real estate professionals screamed about the unfairness of the law as it applied to their industry.
And Congress changed the law by making an exception for real estate people who:
- Work more than 750 hours during the year in real estate, and
- More than one-half of all hours worked were in real estate.
If you meet both of the above tests, you can deduct losses from your real estate activities to your heart’s content.
Bill Lewis is a Vietnam veteran. He took injuries as a Marine, retaining 50 percent use of his right arm and 70 percent of his feet, requiring him to wear orthopedic shoes. The military gave him a disability pension. He now needs knee surgery, and he has difficulty seeing. He is married.
He and his wife own a triplex next door to their residence. The property also has a washhouse, although I am uncertain what a washhouse is. There are six 64-gallon recycling bins, and several large walnut trees. Mr. Lewis does not ask anyone to take care of his property. He takes care of it himself.
- Every morning he walks around and inspects for trash, as they are located very close to a homeless area. This takes him about a half hour daily.
- Also on Mondays he scrubs down the washhouse. That requires him to haul water and takes him about three hours.
- On Tuesdays and Thursdays he landscapes, cleans the outside of the buildings and the garbage cans and rakes the yard. This takes about two hours on each day.
- Depending on the season, he has more raking to do, as he has walnut trees on the property.
- On Wednesdays he takes the recycling bins out to the curb. One by one, as he has mobility issues.
- On Thursdays he returns the recycling bins. Same mobility issues.
- He prefers to do repairs himself. If he needs outside help, he schedules and meets with that person.
- He follows a set routine, rarely if ever taking a vacation.
The Lewis’ claimed rental losses for 2010 and 2011. The IRS disallowed the losses and wanted almost $11,000 in taxes in return. The IRS said this was the classic passive activity.
The IRS should have also taken candy from a child and kicked a dog and made this a trifecta of bad choices.
Mr. Lewis was disabled. He did not have a job. As a consequence, he did not have to worry about spending more than half of his work hours in real estate. For him, all of his work hours were in real estate.
But Mr. Lewis ran into two issues:
- He did not keep a journal, log or record of his activities and hours; and
- The IRS did not believe it could possibly take more than 750 hours to do what he did.
Issue (1) is classic IRS. I have run into it myself in practice. The IRS wants contemporaneous records, and few people keep time sheets for their real estate activities. The IRS then jumps on after-the-fact records as “self-serving.” The IRS has been aided by people who truly could not have spent the hours they claimed (because, for example, they have a full-time job) as well as repetitively fabulist time records, and the courts now routinely side with the IRS on this issue.
But not this time. The judge was persuaded by the Lewis’ testimony and the few records they could provide. This was a rare win for the taxpayer.
The IRS had a second argument though: it should not have taken as long as it took Mr. Lewis to perform the tasks described.
The judge dismissed this point curtly:
"Petitioner husband and petitioner wife testified credibly that because of petitioner husband’s disabilities all of the activities took him significantly longer than might ordinarily be expected.”
The Lewis’ won and the IRS lost.
These were very unique facts, though. Unless one truly works in the real estate industry, many if not most are going to lose when the IRS presses on contemporaneous records for the 750 hours. Mr. Lewis was a sympathetic party, and the judge clearly gravitated to his side.
Which raises the question: why did the IRS pursue this? They were anything but sympathetic chasing a disabled veteran for taking too long while performing his landlord responsibilities.
Yes, I am sympathetic to Mr. Lewis too.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.