Real Estate Investor Loses in Tax Court
Once again, the US Tax Court has ruled against a taxpayer due to insufficient record-keeping. In Lucero v. Commissioner, TC Memo 2020-136, the Court denied rental property losses on a personal income tax return due to poor records. This cost the taxpayers over $15,000 (plus interest) simply because they could not prove the total amount of time the husband worked at their rental property.
In general, a landlord is permitted to claim all ordinary and necessary operating expense as tax deductions against any rental income. This can work to effectively zero out any rental income for tax purposes. In addition, a landlord can deduct a loss and use the loss to reduce income taxes in certain situations. As you probably guessed, there are many rules in this complex area of the tax laws, and one of the rules is that the landlord must “materially participate” in the rental activity.
“Material participation” requires participation in the activity on a “regular, continuous, and substantial” basis. There are 7 different tests for “material participation” and each involves keeping time records relating to the rental activity. In Lucero, the taxpayer needed to prove that he provided more than 100 hours of services related to the rental activity. This he could not do.
The first hurdle was that he did not keep any current time records. Instead, he attempted to reconstruct time records during the audit process. While the Tax Court will permit reconstructed records, it is always better to have records maintained at the time the services were actually performed. The problem here, and the second hurdle, was that the Court did not find the reconstructed records to be credible.
The records showed that the taxpayer spent 267 and 273 hours for the two tax years at issue. The Court eliminated some of the hours, as commuting times to the property was not permitted, along with any investor activity (financial statements, tax returns, etc.). The Court also went through the other entries and determined that these were not credible, including spending 2 hours at a Bed, Bath and Beyond shopping for coffee filters!
Given that the court determined the records to be unreliable at best, the Court denied the losses on the Forms 1040.
HOW TO AVOID THIS ISSUE: Always maintain contemporaneous written records of any activities for which the IRS requires a calculation of your time. Always.