The U.S. District Court for the Western District of Arkansas recently held that all of a taxpayer’s work for his employer, a property management company, counted toward the taxpayer’s satisfaction of the material participation standard where the taxpayer, in his individual capacity, owned interests in properties managed by his employer. Stanley v. United States, 116 AFTR 2d 2015-6766 (November 12, 2015).
During the years in issue, the taxpayer worked for Lindsey Management Co., Inc. (“LMC”). LMC provided management services for residential rental real estate and golf courses in Arkansas and the surrounding area. As part of his compensation for services, the taxpayer was granted 10% of the stock of LMC. While employed by LMC, the taxpayer also independently acquired ownership interests in various entities that owned or operated the residential rentals and golf courses that LMC managed. The taxpayer reported income and losses from these activities as non-passive on his Federal income tax returns. The IRS determined that all of the taxpayer’s independent activities constituted passive activities.
Generally, a taxpayer may use losses from a passive activity only to offset income from a passive activity. I.R.C. § 469(a), (b). Rental activities are per-se passive activities. I.R.C. § 469(c)(2). A taxpayer can avoid this rule if the taxpayer shows that he is a real estate professional; i.e., if (1) more than half of all of the personal services performed by the taxpayer were performed in real property businesses in which the taxpayer materially participates and (2) the taxpayer performed more than 750 hours of services in real property businesses in which the taxpayer materially participates. I.R.C. § 469(c)(7)(B). An employee’s work for an employer engaged in the real property business generally is not included in determining whether a taxpayer is a real estate professional unless the taxpayer-employee owns more than 5% of the equity of his employer. I.R.C. § 469(c)(7)(D).
A taxpayer’s business activities are considered to be separate activities unless the taxpayer elects to aggregate them. The taxpayer can make this election only if “the activities constitute an appropriate economic unit”. 26 C.F.R. § 1.469-4(c)(1). Whether the activities constitute an economic unit depends on the similarities and differences between the activities, whether there is common control or ownership over the activities, the geographical location(s) of the activities, and whether the activities are interdependent. 26 C.F.R. § 1.469-4(c)(2). Rental real estate activities can be grouped with other activities only if (1) the rental activity is insubstantial compared to the other business activity or vice versa; or (2) each owner of the business activity has the same proportionate ownership of the rental activity.
Because the taxpayer owned more than 5% of LMC and the taxpayer materially participated in LMC’s property management business, the court concluded that the taxpayer was a real estate professional for the years at issue. Further, all of the taxpayer’s work at LMC would be included in determining whether the taxpayer materially participated in his independent rental real estate activities, not just the taxpayer’s work at LMC with respect to properties owned directly or indirectly by the taxpayer. The court also concluded that the taxpayer properly aggregated all of his rental real estate activities together. The facts and circumstances indicated that the activities were a single economic unit; specifically, the rental properties all were managed by LMC, a related entity provided telecommunications services to all of the properties, the same person(s) exerted control over all of the rental properties, LMC, the telecommunications provider, and the golf courses, the rental properties and golf courses were all located in Arkansas and the surrounding areas, and the business model of LMC linked residential rental real estate and the operation and rental of golf courses.
Real estate professionals who engage in independent rental real estate activities should be aware of the court’s broad reading of the material participation standard. Here, the court allowed the taxpayer to count all of the time spent in his daily job toward satisfying the material participation standard with respect to his rental real estate activity. The Stanley case will be helpful for real estate professionals who work full-time jobs and also engage in independent rental real estate activities, provided the taxpayer’s facts are substantially similar to the facts in Stanley.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.
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