Lesson From The Tax Court: The Shrinking §469 Exception For Active Participation

Section 469 generally denies taxpayers the ability to use net losses from passive activities to offset income from active activities.  Renting real property is a passive activity.  But there are some exceptions when it comes to renting real estate.  Two are relevant for today’s lesson.  First, taxpayers who are real estate professionals can deduct such losses.  Second, individual taxpayers who actively participate in a rental activity can use up to $25k of net losses to offset other income ... if they are not too rich!

Today we learn how difficult it can be for taxpayers employed in a full-time job to claim they are a real estate professional.  We also learn how second exception is shrinking.  In Timothy L. Foradis and Jessica L. Moore v. Commissioner, T.C. Summ. Op. 2024-13 (July 11, 2024) (Judge Leyden), the married taxpayers attempted to deduct some $22k in net rental losses on their 2020 return.  But they were too rich!  That exception closes when taxpayers have AGI of over $150,000.  This couple had total wage income of just over $161k.  So they were forced to try and sell Mr. Foradis as a real estate professional.  It did not go well.

Details below the fold.

Law: The Basics of §469 Passive Loss Rules
Congress added §469 to the Code in the Tax Reform Act of 1986, Pub. L. 99–514, 100 Stat. 2085, 2233.  The idea behind it is that there are two kinds of taxpayers: those who work for their income and those who sit back and let others work it for them.  Congress had become suspicious that the latter kind of taxpayer would invest in schemes that had no economic substance beyond generating tax benefits (generally paper losses).  They could then use those losses to offset their real income, often from high salaried positions.  See Joint Committee Staff, “General Explanation of Tax Reform Act of 1986” (“JCT Bluebook”) (May 4, 1986) at 209-215.

Section 469 works by differentiating losses incurred by each type of taxpayer:  those who actively work for their income and those who just invest in an activity and then passively let others work it.  Specifically, §469(a) puts losses and income into two buckets: (1) those resulting from an active activity and (2) those resulting from a passive activity.  It then applies a like-to-like rule: passive activity losses (PALs) may only offset passive activity income.  They may not be used to offset active activity income.  Unused PALs may be carried forward into the next year. §469(b).

So what’s the difference between an active income-producing activity and a passive one? Well, §469(c) tells us.  The general definition in (c)(1) says that passive activities are those in which the taxpayer does not materially participate.  The idea here is that a “taxpayer who materially participated in an activity [is] more likely than a passive investor to approach the activity with a significant nontax economic profit motive, and to form a sound judgment as to whether the activity had genuine economic significance and value.”  JCT Bluebook at p. 212.  For today’s lesson we do not need to tease out what constitutes material participation.  For those who care, I discussed that in Lesson From The Tax Court: Why Vacation Home Losses Are Difficult To Deduct, TaxProf Blog (Oct. 5, 2020).

Following the general definition of passive activity comes a list of specific types of passive activities.  For today’s lesson, we focus on §469(c)(2) which tells us that “any rental activity” is passive per se.  And that includes renting real property.  Section 469(c)(4) says that is true regardless of whether there is material participation in the rental activity.

But since this is a tax statute, the word “any” does not really mean “any.”  There are several situations where a rental activity might actually not be a passive activity or, even if it is, the taxpayer can make some use of the losses against active income.  You can call them exceptions.  Or if you want to be snarky, call them loopholes.

Today’s lesson looks at two: the exception for real estate professional and the one for active participation.

Law: The Real Estate Professional Exception
Section §469(c)(7) provides that rental activities of certain types of taxpayers are not passive activities.  What kind of taxpayers?  Well, most people (including Judge Leyden) call them real estate professionals.  I’ll call them that as well.  Section 469, however, does not use this term.  Section (c)(7) calls them “taxpayers in real property business.” and sets out three tests for taxpayers to qualify as being in the real property business:

(1) Material participation test:  the taxpayer materially participates in a “real property trade or business.”  That term is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”  §469(c)(7)(C).

(2) Hours worked test: the taxpayer performs more than 750 hours of services during the taxable year in that real property trade or business.  §469(c)(7)(B)(ii); and

(3) Proportionality Test: the hours that the taxpayer puts into that real property trade or business must be more than half of all the hours that the taxpayer puts into their active activities.  §469(c)(7)(B)(i).

Married couples filing joint returns are allowed to combine their efforts to determine if they meet the material participation test, §469((h)(5), but not the other two tests.  That is, Treas. Reg. 1.469-9(c)(4) says that one spouse must separately satisfy both the Hours Worked test and the Proportionality test.  Notice that if a taxpayer’s proportionality test is more than 750 hours (e.g. the taxpayer works 800 hours in another activity and so must show they worked more than 800 hours on the rental), then proving that will also prove the Hours Worked test.

As you might expect, all of this requires the taxpayers to prove up their hours.  No Cohan rule can save them here!  But they must do more than just show the hours they put in to the rental.  In order meet the Proportionality Test, they must also show how many total hours they put into their other work.  Treas. Reg. 1.469-5T(f) gives the rules but the basic idea is that taxpayers must substantiate with adequate records, with contemporaneous records being the best.

Law: The Active Participation Exception 
Section 469(i) also allows certain individual taxpayers to deduct up to $25,000 of losses from rental real estate activities from active income, such as that from wages or investments.  They don't have to be real estate professionals.  Basically, Congress says that a little bit of sheltering ($25k worth) is ok as long as the taxpayer is not too rich.  Let’s see how that works.

This exception is for who have an ownership interest of at least 10% in the real property being rented out and who actively participate in the rental.  Active participation is a lesser standard than material participation.  It just requires the taxpayer to participate in significant management decisions, such as approving tenants, approving major expenditures for property repair or improvement.  The best guidance still comes from the JCT Bluebook at 244 which says:

“The difference between active participation and material participation is that the former can be satisfied without regular, continuous, and substantial involvement in operations, so long as the taxpayer participates, e.g., in the making of management decisions or arranging for others to provide services (such as repairs), in a significant and bona fide sense. Management decisions that are relevant in this context include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions.”

The IRS has pretty much cut and pasted this language into its Publication 925 (2023).

But a taxpayer cannot be too rich.  It's a middle-class/upper-middle class loophole exception.  The $25,000 benefit phases out as a taxpayer’s modified AGI exceeds a $100,000 threshold.  Section 469(i)(3)(E) contains special rules for making the modifications to AGI.  For example, you don’t have to include Social Security payments in the AGI calculation but you do have to include income from U.S. Savings bonds even if that income is excludable under §135.  And there are more fussy rules.  But those details are beyond the scope of today’s lesson.

The phaseout is not dollar-for-dollar.  Rather §469(i) reduces the amount of PALS that can be offset against active income by $0.50 for every $1 a taxpayer’s AGI exceeds the threshold.  For example, a taxpayer’s AGI of $110,000 reduces the tax benefit by $5,000.  As a result the taxpayer can now deduct only up to $20,000 of PALs from rental real estate against active income.  Well, that’s does not hit hard if you are only running a $10,000 loss!

What hits hard is the that the tax benefit is reduced to zero when a taxpayer’s AGI exceeds $150,000.  That’s when a taxpayer is too rich.  And that’s the cut-off regardless of whether the taxpayer is filing singly or filing jointly.  Taxpayers who are too rich need to try and shoehorn themselves into one of the other exceptions, like the real estate professional.  Well, as we will shortly see, good luck with that!

Facts
Mr. Foradis and Ms. Moore were married filing jointly in 2020.  On that return they reported total wage income of around $161k (some $83k for Ms. Moore and $78k for Mr. Faradis).  They also reported a real estate rental activity, consisting of a “carriage house” they had built in 2020 to rent out.  It is not clear from the opinion whether they built this on the same lot as their principal residence (e.g. their back yard) or whether it was on a entirely separate plot of land.  I am not sure it makes a difference for the §469 analysis, but would welcome comments on whether it might make a difference for potential §280A application.

On their 2020 return they reported a small amount of rents and a very large amount of expenses, resulting in net loss of over $22k.  That makes potential sense when one considers this was the year they were building the carriage house.  At any rate, they claimed the loss as a deduction against their wage income.

On audit the IRS denied the loss.  First, under the general rules in §469 they could not offset their active income from salaries with the passive loss from the rental.  Second, they did not qualify for the active participation exception because their combined wages of $161k meant their modified AGI was more than the $150k cutoff.  Third, neither of them qualified for the real estate professional exception.

In their petition to Tax Court the taxpayers did not argue about the active participation exception: they were too rich.  They instead attempted to argue that they qualified for the real estate professional exception.  Remember, while they could combine efforts to meet the material participation test, they could only use one of them to meet the other two tests (hours worked and proportionality).  Here, they attempted to use Mr. Foradis’s efforts.  In 2020 he had worked full-time, 40 hours per week.  And he took 2 weeks of what they now call “Personal Time Off.”

So to meet the proportionality test they needed to show Mr. Foradis put in more than 2000 hours on the real estate activity.  That would also be more than the minimum 750 hour requirement in §469(c)(7)(B).

Lesson 1: It Is Hard To Prove Two Full Time Jobs
In Tax Court the taxpayers claimed that Mr. Foradis put in approximately 2,500 hours, plenty more than the 2,000 he needed to prove.  They offered receipts and logs, but apparently relied most heavily on his testimony.  He testified in Court that he worked a 40-hour-per-week full time job and had taken 2 weeks vacation in 2020.  He said that he worked on the real estate activity both after work, on weekends, and during the 2-week vacation.

Judge Leyden did not believe him.  She wrote “The Court finds it implausible that Mr. Foradis, as he asserts, would work 40 hours each week at a full time job and at the same time work about an additional 48 hours each week constructing the carriage house.”  Op. at 5. Once she made that finding, Judge Leyden said “the Court need not address the reasonableness of the receipts or logs” the taxpayers had offered.  Id.

If what Mr. Foradis said was true, then that would mean he was working 88 hours a week working one of his two full-time jobs.  That would leave him about 80 hours a week for eating, cleaning, bathing, sleeping, and commuting, not to mention relaxing.  Assuming the time for bed/sleep/wake was 56 hours (8 hours a day) that left him about 3 hours a day for everything else one does in life.

Bottom line: the lesson here is not whether you or I think that Mr. Foradis’ testimony was, in Judge Leyden’s words “implausible.”  We aren’t the judge.  The lesson is that taxpayers need to do much more than simply expect a Court to accept their say so.  Even if they don’t have documents, they should be prepared to offer the testimony of other witnesses, witnesses who have nothing to gain by testifying: neighbors, family, contractors, etc.  Somebody whose testimony would not be perceived as self-serving.

Lesson 2: The Shrinking Exception
The $25,000 active participation exception has never been indexed for inflation.  Congress created it in 1986 and it has remained the same amounts: a phaseout threshold of $100,000 with a range of $50,000, and thus an end point of $150,000.

Sure, an income of $150,000 is still pretty substantial, even today.  According to this page from the DQYDJ blog (“Don’t Quit Your Day Job”), that was higher than the income of about 78% of other households in 2023.  But it was a much, much, higher percentile in 1986.  I cannot find out just how much (happy for an alert reader to help out!), but according to this inflation calculator website, I learned that what $150k would buy you in 1986 would cost you approximately $430k in 2024.  And then flipping back to DQYDJ, that amount was the 97th percentile of household income in 2023.  So it is likely that in 1986 the exception was available to taxpayers in about the 95th percentile of income or below.  Now it has shrunk to taxpayers in about the 78th percentile or below.

By any measure it appears that what was “too rich” in 1986 is now just “too middle class.”  For more details on what constitutes “middle class” here is a fun calculator from the folks at Pew Research Center.  The $25,000 exception is shrinking, available to fewer and fewer middle income households as time goes by.  I do not claim this to be a good thing or a bad thing.  But I do claim is something to think about! 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return on the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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