Tax Court Rulings on Real Estate Professional Status, Passive Activity Losses, Deductions, and Hobby Losses
Table of Contents
1. Real Estate Professional Status & Passive Activity Losses
IRS.gov Reference: Passive Activity Losses – Real Estate Professionals
The most critical theme across these cases is the challenge of qualifying as a Real Estate Professional under IRC §469(c)(7). This status is crucial for investors to deduct rental real estate losses against active income (e.g., W-2 wages).
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Key Requirement: The taxpayer must meet two tests:
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Time Test: More than 50% of personal services performed in trades or businesses during the year are in real property trades or businesses in which the taxpayer materially participates.
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Hours Test: Perform more than 750 hours of service in those same real property trades or businesses.
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Common Reasons for Failing (as seen in the TCMs):
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Inadequate Recordkeeping: Taxpayers failed to maintain contemporaneous, detailed logs of hours spent on rental activities. The court consistently rejects estimates and reconstructed logs.
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Example Cases:
TC_Memo_2012-83,TC_Memo_2013-199,TC_Memo_2018-109
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Failure to Materially Participate: Even if the time and hour tests are met for the collection of properties, the taxpayer must also materially participate in each rental activity individually (unless a valid election to aggregate rental interests is made).
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Example Cases:
TC_Memo_2007-350,TC_Memo_2010-39(Note: 2010-41 is used as a proxy)
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W-2 Job Conflicts: Taxpayers with full-time, high-hour W-2 jobs often cannot prove they also spent over 750 hours on their real estate activities.
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Example Cases:
TC_Memo_2001-78,TC_Memo_2004-140
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2. Deduction Substantiation: “Ordinary and Necessary” Expenses
IRS.gov Reference: Deducting Business Expenses
The Tax Court repeatedly disallows deductions due to poor substantiation. Under IRC §162, expenses must be “ordinary and necessary” and the taxpayer must prove the amount and business purpose.
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Travel, Meals, and Auto Expenses: Without a mileage log, appointment book, or receipts connecting the expense directly to a rental activity, these deductions are routinely denied.
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Example Cases:
TC_Memo_2005-232,TC_Memo_2011-219
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Home Office Deduction: Taxpayers must prove exclusive and regular use of a portion of the home for business. Mixed-use spaces (e.g., a guest bedroom/office) fail the “exclusive use” test.
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Example Cases:
TC_Memo_1993-63,TC_Memo_2007-134
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Repairs vs. Capital Improvements: The distinction is critical. Repairs (deductible) maintain a property’s value, while improvements (capitalized) add to its value or prolong its life.
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Example Cases:
TC_Memo_2004-222,TC_Memo_2012-243
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3. Hobby Losses: Activity Not-for-Profit
IRS.gov Reference: Hobby or Business?
Under IRC §183 (the “hobby loss” rule), the IRS can challenge an activity if it is not engaged in for profit. This affects real estate “flipping” or development ventures that show consistent losses.
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The 9-Factor Test: The court uses a facts-and-circumstances test, including:
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The manner in which the taxpayer carries on the activity.
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The expertise of the taxpayer or their advisors.
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The taxpayer’s history of income or losses.
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The elements of personal pleasure or recreation.
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Implication: If an activity is deemed a hobby, deductions are limited to the income from that activity; losses cannot be used to offset other income.
Related TC Memo Links:
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TC_Memo_1977-166(A classic case on business intent)
4. Depreciation and Basis Issues
IRS.gov Reference: Publication 946, How To Depreciate Property
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Correct Basis Calculation: Depreciation must be calculated on the correct cost basis of the property. Errors in allocating purchase price between land and building are common.
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Depreciation Recapture: Upon sale, depreciation deductions taken are “recaptured” and taxed at a higher rate than capital gains.
Related TC Memo Links:
Conclusion & Actionable Insights for REISkills Clients
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Meticulous Recordkeeping is Non-Negotiable: Use a dedicated log (digital or paper) to track hours, mileage, and expenses contemporaneously.
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Understand Real Estate Professional Status: Do not assume you qualify. The tests are strict, and the burden of proof is on the taxpayer.
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Separate Business from Pleasure: Maintain separate bank accounts and credit cards for all real estate activities to simplify recordkeeping and substantiation.
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Seek Professional Advice Early: Consult with a tax professional who understands real estate before filing your return, especially if you have significant losses or complex activities.
Disclaimer: This report is a summary of common themes for educational purposes and is not a substitute for professional tax or legal advice. The outcome of any case depends on its specific facts and circumstances.
