Material Participation in Rental Properties-IRS Audit Case-$55,000 Result

July 2nd, 2021 at 4:39 PM

Let me tell you about Lisa and Jimmy.

They had a very unsatisfactory visit with the IRS. The auditor examined their three rental properties, disallowed their losses, and told them to expect a tax bill for $55,000.

Current score: IRS $55,000 ahead.

But one good thing happened during the visit. The IRS agreed that Lisa was a real estate professional.

The bad thing was that the IRS said that Lisa did not materially participate in the rentals, because the more than 750 hours shown in her logbook included what’s called investor time.

With this, the IRS examiner said that although Lisa is a real estate professional, she failed to materially participate in the properties because she had fewer than 500 hours of material participation.

Properties

Lisa and Jimmy’s rental properties include

• a condo rented on a month-to-month lease,
• a single-family home rented on a month-to-month lease, and
• a vacation cabin rented on a one-week basis for 20 weeks a year.

They have no personal use of the rentals.

Here’s how the tax law assisted Lisa and Jimmy; firstly, by explaining that the 500 hours are not relevant. Secondly, the 500-hour rule is just one of seven possible material participation tests that you find in IRS Reg. Section 1.469-5T(a)(1).

Condo. To show the IRS that Lisa and Jimmy materially participated in the condo, an astute CPA used the “more than 100 hours” test. This test requires that Lisa’s and Jimmy’s participation be more than 100 hours and not less than participation by any other individual.

In addition, one can refer to the Pohoski case as our position. In this court case, the taxpayer had to count only the time that front-desk personnel actually spent on his unit, not the total time that they manned the desk. The IRS accepted that Lisa and Jimmy met that test.

Single-family home. Since Lisa and Jimmy did everything in connection with this rental, the IRS had no choice but to allow material participation under the “substantially all” test (one of the seven tests).

Vacation cabin. Lisa did all the work for the vacation cabin, except for that done by a housekeeper who spent three to four hours for each of the 20 weeks that the vacation cabin was rented (say 3.5 x 20 weeks, for a total of about 70 hours of housekeeping). The Taxpayer won material participation here, because Lisa’s and Jimmy’s combined efforts were more than 100 hours and more than the housekeeper’s 70 hours.

The combination of an experienced CPA, and Lisa’s and Jimmy’s good tax records enabled Lisa and Jimmy to obtain a “no change” letter—meaning that the $55,000 IRS claim was eviscerated.

Mark S. Fineberg, CPA