Know Why the Court Denied Losses on Four of Six House RentalsTax Planning
If your rental property shows a loss for the year, you want to deduct that loss against your other income.
In the good ol’ days (before the Tax Reform Act of 1986), you always did that. And when you did that, your after-tax rate-of-return from the rental increased.
With the loss deduction subsidy, your government helped you grow your rental property profits.
You still can use the loss deduction subsidy benefit on your rental properties if you can jump over the passive-loss hurdles.
Example. You have $50,000 in rental property losses this year, but you fail the passive-loss rules; therefore, your current-year deduction for the losses is zero. That’s ugly, isn’t it? Sadly, it’s also true.
If you own rental properties and want to deduct rental losses, you absolutely, positively must have a handle on the passive-loss rules.
This article will help you understand and plan your rental property activities for tax deductions by giving you insights from the Miller case.
Who Are the Millers?
Tom and Nancy Miller claimed losses of $71,464 in year 1 and $143,091 in year 2 from their rental real estate activities for the two years at issue before the court.
During the years at issue, Mr. Miller held a full-time position as a tugboat pilot who navigated commercial and military seagoing vessels into harbors and rivers in the San Francisco Bay Area and Sacramento, California. In this capacity, Mr. Miller worked a schedule of seven days on duty, followed by seven days off duty.
During the years at issue before the court, Mr. Miller held a Class B general contractor’s license and provided construction services for clients, including remodeling kitchens, replacing home siding, building decks and fences, and replacing windows. He also drafted and worked on building plans for houses.
The Passive-Loss Issue
To deduct their rental property losses, either Mr. or Mrs. Miller must first qualify as a real estate professional.
Once either Mr. or Mrs. Miller meets the tax law rules to qualify as a real estate professional, then together they can “materially participate” in each of their six rental properties. For each property in which they materially participate, the Millers can deduct their rental losses against all other income.
Note. Had the Millers made the tax code election to group their rental properties, the “material participation” rule would have applied to the group rather than to each of the six properties.
Real Estate Professional
Mr. Miller qualified as a real estate professional because, during each year at issue, he
- spent more than one-half of his personal service time in real property trades or businesses in which he materially participated, and
- spent more than 750 hours of service in real property trades or businesses in which he materially participated.
Planning point. Investor time counts for the 750-hour test but not for the more-than-half-your-personal-serviceswork-time test. The 750 hours is for services. The more-than-half is for “personal services.”
How did Mr. Miller prove that he spent more than one-half of his personal service time in real property trades or businesses?
Since this is a time test, guess what Mr. Miller had in his tax-deduction arsenal? What one thing did he need and have?
If you said “time log,” you are right. In court, Mr. Miller presented contemporaneous work logs for his construction
and rental activities and provided compelling testimony and witnesses.
Rule 1. Keep a time log. Make sure your time log proves you pass the
- more-than-half-your-work-time test,
- more-than-750-hours test, and
- material participation tests for each of the properties, or group, if you elected to group them.
You might ask: What about Mr. Miller’s job as a tugboat pilot, where he works seven days and then has seven days off? Wouldn’t that kill the more-than-50-percent test? No, and here’s why.
Mr. Miller’s tugboat activity does not require him to work all seven days. His schedule is somewhat flexible and predictable. He knows roughly when he has to work during his “on” time, and he can trade turns in the pilot rotation, subject to limitations. Thus, he has some real estate and contractor time during his pilot “on” time.
Death of Four Rental Loses
How did the Millers lose their rental property losses on four of the six properties?
Answer. On four rentals, they failed the material participation test.
Tax law contains seven possible material participation tests. The Millers materially participate in a property if they pass any one of the seven tests. In this case, only two of the seven material participation tests applied to the Millers’ situation, as follows:
- The Millers materially participate in a rental if they perform substantially all the work on the rental.
- If others participate in a rental, the Millers materially participate if (a) they participate in the rental 100 hours or more and (b) have no other individual participate more than the Millers.
On two of the rental houses, the court found that the Millers worked more than 100 hours and that work was not less than the work of any single individual. Accordingly, the court allowed the tax losses on those two rentals.
On the other four rentals, the Millers either
- did not participate in the rental 100 hours or more, or
- did participate 100 hours or more but did not participate more than any other individual.
Note two things here. First, the 100-hours-or-more test is another time test in need of a time log. Second, for the seven material participation tests, tax law looks at the combined efforts of husband and wife.
Avoid Death of Deductions
You will find the Millers’ material participation failures instructive.
The problem begins with participation by others in the rental houses. When others participate, you trigger the 100- hour rule.
Here is how the work of others on the four rentals triggered the 100-hour rule:
- On the Morning Glory property, a single-family home, Mr. Miller paid his brother, who oversaw the installation of carpet, hired a fence company to install a fence, worked on the installation of fences, and occasionally mowed the lawn. (The brother, carpet installers, and fence company triggered the 100-hour rule.)
- On the Lind property, a single-family home in a community governed by a homeowners’ association, the Millers paid monthly association fees for maintenance of common areas and for mowing and maintenance of the front yards of the homes within the community. (The front-yard workers triggered the 100-hour rule.)
- On the Price property, a single-family home, the Millers hired a landscaper at $65 a month to provide weekly mowing and gardening services. (The landscaper triggered the 100-hour rule.)
- On the Emerald property, a single-family home, the Millers hired an individual to provide mowing and gardening services. (The mowing and gardening services triggered the 100-hour rule.)
On each of these four properties, the Millers either could not prove
- that they worked 100 hours or more on the rental house, or
- if they worked 100 hours or more, those hours were equal to or more than the work of any other individual.
By failing this material participation test, the Millers were not allowed to deduct the rental losses on the four rental houses during the years before the court. That’s the bad news.
The good news is that the losses were not lost. Assuming continued real estate professional status, the Millers have three different scenarios in which they can use the losses:
- In subsequent years, when they pass the material participation tests on a property, the accumulated losses on that property are deductible.6 (Any loss from an activity that is disallowed under Section 469 (the passive-loss rule section) is treated as a deduction allocable to such activity in the next taxable year.)
- In future years, they can use the losses against passive income from other passive activities.
- In the year they sell or otherwise dispose of their entire interest in a rental house to a third party, they may deduct the total accumulated passive losses.
What This Case Teaches
Had the Millers chosen to group their properties, they would have passed the material participation test of personal service work time greater than 500 hours for the group of six rentals.9 To put this in context for the Millers, using the group and then passing the material participation test for the group would have allowed their claimed tax losses of $71,464 and $143,091.
Besides bringing up the “group or not to group” question, this case teaches the need for an accurate time log.
The Millers failed the more-than-100-hours test when they had outside help on their rentals. Had they kept a log on each of the rentals, they would have known that they
- either failed the 100-hour test or
- needed to group.
In other words, the time log is step one. Knowledge of what the time log means is step two. The combination shows you the road to follow.
The time log is critical to enable your rental property loss deductions. You need it to prove that
- you pass the 750 hours test,
- you pass the more than 50 percent work-time test, and
- you materially participate in each individual property (unless grouped).
Of course, your time is only part of the equation when you have others working the rental property. With other workers, their time becomes important, too. Here, because of the work of others, you need to work more than 100 hours, and that work may not be less than the work of any other individual. Make sure you can prove it.