Today we’re going to look at a recent Tax Court case regarding a husband and wife partnership with rental property. An example of when rental activities go wrong! In the case of Dunn v. Commissioner, TC Memo 2022-112, the married couple lost deductions for their rental losses through a comedy of errors and misapplication of tax rules. This is a great case to review! You’ll see firsthand how the IRS and Tax Court view things when a couple ignores the tax rules.
Heather & Edison Dunn formed a partnership called Magnet Development LLC to manage their two rental properties located in Georgia. They timely filed a partnership return since they each owned 50% of the LLC. This was a good first step, and one of the few things they did that followed the tax rules. We often see clients that fail to realize they have created a partnership when splitting ownership of an LLC.
Things quickly went off the rails from here…
Claiming Real Estate Professional Status
The taxpayers claimed a full deduction for rental losses from the partnership on their personal 1040 return. The trouble is, rental losses are considered passive under IRC §469 unless you prove that they aren’t. Passive losses can’t offset other income like wages.
In order to qualify as a Real Estate Professional, one of the partners would need to meet the following tests:
- Perform more than 50% of their work in real property trades or businesses
- Perform more than 750 hours of service in real property trades or businesses
The trouble here is that both Heather and Edison had full time jobs outside the real estate industry. One was a technology support specialist in a school district and the other a computer specialist for a private company. It is generally impossible to meet the real estate professional rules with a full time job. One would need to work more than 4,000 hours in a year to meet the 50% test above. In the Court’s summary, they noted that logs kept by the taxpayers were scant of verifiable information. Hours were often not listed and descriptions of tasks performed were 2-3 word summaries at best.
Material Participation Rules
The Court went on to determine if the taxpayers could avail themselves of the Material Participation Test since they clearly didn’t qualify under the Real Estate Professional test. There are seven tests and satisfying any one of these tests can allow rental losses to be deducted.
- The individual participates in the activity for more than 500 hours during the tax year.
- The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year.
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year.
- The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours.
- The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year.
- The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous and substantial basis during the year
What Did the Tax Court Determine?
The Court found that once again the records kept by the taxpayers were insufficient noting:
“In 2013 and 2014 both petitioners worked full-time jobs unrelated to real estate. They provided logs that purported to show their collective rental real estate activities during that time. The logs show 767 hours worked in 2013 and 407 hours worked in 2014; however, the logs do not specify which petitioner worked these hours. Moreover, the hours recorded in the logs are inflated because petitioners included not only hours spent performing activities related to rental real estate, but also the hours they spent physically present at the properties.”
The Court goes on to remind the spouses that at least one of them needed to spend 750 hours and that they failed to document hours by spouse in their time log. The couple also failed to document that no other person spent more time than them at the properties.
In addition to the denied rental losses, the couple attempted to deduct a new Ford Explorer. The taxpayers unfortunately didn’t keep mileage logs for the vehicle which is almost always fatal in Tax Court cases. They lost these deductions as well.
Partnership Structural Issues
It’s important to note that when you have an LLC or Partnership, certain formalities need to be kept for both legal liability and tax concerns. For example, it’s always a good idea to keep separate bank accounts and credit card accounts for the business to keep your personal assets separate from the business.
It’s also important to title assets correctly so that the business owns assets it is deducting.
In this case, the Dunn’s didn’t legally transfer the two rental properties into the LLC’s name. The Tax Court took a dim view on this and rightly concluded that the partnership never even had any business income or loss since it never owned the rental properties in the first place.
While the case transcript doesn’t indicate the reason this wasn’t completed, I suspect the couple never completed the title transfer because they needed to take out a loan in their name to get financing. After the original title transfer, I think they just never got around to completing the title transfer. Or maybe assumed it wasn’t important. They were wrong.
Since they never transferred the title of the properties to the partnership, the Tax Court treated them as never contributing anything of value to the partnership. As such, they had no “basis” in their partnership shares. And therefore, were (once again) barred from taking any losses from the partnership K1 on their return.
While there were quite a few errors made by the taxpayers in this case, I hope you were able to take away a few tips so you can avoid the same fate as the Dunns.