If you’re a landlord whose rentals lose money, it may mean a lot if you qualify as a real estate professional for tax purposes.
Nothing illustrates this fact of life better than a brand-new case handed down from the U.S. Tax Court involving Najeem and Olubunmi Adeyemo, a married couple who owned seven rental properties in Maryland.
During the housing downturn, the Adeyemos experienced difficulty renting out their properties and collecting rent from tenants. As a result, they incurred substantial losses: $171,651 in 2008 and $96,806 in 2009.
Fortunately, they did have other income: Mrs. Adeyemo worked full time as a pharmacist, and Mr. Adeyemo worked in pharmaceutical sales. Their joint wage income was $232,992 in 2008 and $175,354 in 2009.
So, the Adeyemos had big rental losses and a big income. Could they deduct the former from the latter and drastically reduce their income taxes for years in question?
Unfortunately for the Adeyemos, the U.S. Tax Court, in its first decision of 2014, concluded that the answer was “no.” The reason was the dreaded passive activity loss rule.
Under the passive activity loss rules, all rental losses are automatically deemed to be passive losses that are deductible only against other passive income, not against nonpassive income such as wages or active business income.
There are only two exceptions.
First, up to $25,000 in rental losses can be deducted by taxpayers whose incomes are below $100,000 per year. However, the Adeyemos earned too much money to qualify (this deduction is phased out for landlords with incomes of $100,000 to $150,000 per year).
The other exception is for real estate professionals. Any person who qualifies as a real estate professional may deduct all the passive losses incurred from rental real estate activities from other nonpassive income. In short, the passive activity loss rules don’t apply to real estate pros.
To qualify as a real estate professional, either Mr. or Mrs. Adeyemo had to show that they:
- spent more than half of their working hours during the year working in one or more real property businesses, and
- spent more than 750 hours a year in one or more real property businesses.
The Adeyemos’ only real property business was rental real estate. Mrs. Adeyemo worked full time as a pharmacist, so she couldn’t possibly qualify as a real estate professional.
That left only Mr. Adeyemo. He appeared to have a real shot at qualifying. He worked only part time in pharmaceutical sales, and did all the work managing the couples’ seven rental properties himself.
Mr. Adeyemo prepared a detailed logbook that the court found to be thorough and credible evidence, even though it was created after the fact, not contemporaneously during the years in question.
It showed that he spent at most 800 hours managing the couple’s rental properties in 2008 and 715 hours in 2009. Although this was a substantial number of hours, it was not enough.
He worked about 1,500 hours at pharmaceutical sales during 2008, so he needed to work at least 1,501 hours at real estate to qualify as a real estate pro that year. His 800 hours for that year didn’t cut it. Meanwhile, the 715 hours he worked at landlording in 2009 fell just below the 750-hour minimum.
Thus, the Tax Court held that the Adeyemos’ couldn’t determine their rental losses from their wage income for those years. Instead, their losses became suspended passive losses — essentially useless for tax purposes until such time as they had passive income to deduct them from or they sold their rental property. (Adeyemo v. Comm’r., T.C. Memo. 2014-1.)
Had Mr. Adeyemo worked in a real estate sales instead of pharmaceutical sales, he could have easily qualified as a real estate professional in both years — he would have passed both the over 50 percent and 750-hour tests.
However, it is extremely difficult, if not absolutely impossible, for any landlord who works in a non-real-estate business to satisfy the over 50 percent test. The IRS is well aware of this fact and is likely to question any such landlord who deducts real estate losses.
Stephen Fishman is a tax expert, attorney, and author who has published 20 books, including “The Real Estate Agent’s Tax Deduction Guide,” “Working for Yourself,” “Deduct It!,” and “Working with Independent Contractors.” His website can be found at fishmanlawandtaxfiles.com.