The $300,000 Log Book

My previous two blog posts were about Tax Court cases that ended unhappily for the tax payers. Before everyone starts thinking Tax Court is just a place where tax payers go to get bad news let me present a case with a happy ending. Sometimes tax payers get good news at Tax Court. Such was the case for Mohammad and Mary (M&M), although I'll admit when I first started reading this Tax Court Memo I didn't expect it was going to end well for them. I thought this was going to be another one of the many cases where someone is trying to claim they were a real estate professional, and found out the hard way what a burden that can be to prove.

M&M are both dentists. In addition to owning and running their own dental practice they are also real estate investors. The dental business and real estate business are separate LLCs. With respect to the real estate business M&M reported the following passive losses for tax years 2010 – 2012:

2010: $221,582

2011: $242,276

2012: $220,788

Big numbers. The kind that seem to draw the attention of the IRS. M&M (of course) wanted to get around the $25,000 passive loss limitation by claiming M1 (Mohammad) was a real estate professional. They deducted all the real estate passive losses against their income from their dental practice for tax years 2010-2012. Upon examination (audit) the IRS was not convinced M1 qualified as a real estate professional, disallowed the passive losses, and issued combined notices of deficiency for the 3 years totaling $342,429 for taxes owed and an additional $68,485 in accuracy-related penalties. (Some of these deficiencies and penalties were due to deductions M&M took for their dental business, but I am going to stick to the parts of their case pertaining to real estate.) M&M disagreed with the IRS determination M1 was not a real estate professional and petitioned the Tax Court for relief.

The IRS did not contest the validity of the real estate expenses claimed by M&M. As far as the IRS was concerned they were all legitimate expenses. They merely disallowed the deduction for passive losses in 2010-2012. The IRS position was that M1 could not legally claim to be a real estate professional, therefore all M&M’s passive losses for the years in question should be suspended because their MAGI (modified adjusted gross income)  exceeded $150,000.

Once the IRS has determined a position they are typically considered to be correct and the burden of proof falls on the tax payers to prove the IRS position is not correct. In order to prove M1 was a real estate professional he had to convince the court that he (1) materially participated in the real estate activities, that he (2) worked at least 750 hours on his real estate business, and that he (3) spent more time on his real estate business than he spent on his dental business. The IRS agreed that he had materially participated, so he only had to prove the 750 hours, and that he worked more in real estate than as a dentist.

M&M provided the court with log books from the years in question that showed M1 had spent more than 1,000 hours each year working on his real estate business. The court was satisfied the logs were authentic and the records had been kept contemporaneously and not thrown together based on after-the-fact estimates.

M&M also testified credibly that M1 only worked 14 hours per week in his dental practice in 2010 – 2012. He had taken off a considerable amount of time to work on his real estate business, and M2 (Mary) was working extra hours to keep the dental practice afloat. Even if M1 worked every week of the year this would only add up to 728 hours per year. Far less than the amount he worked on his real estate business.

The Tax Court therefore found M1 met the standard in the internal revenue code as a real estate professional and removed the limitation on deducting passive losses the IRS had placed on M&M. No additional tax or penalties were owed with respect to their real estate business. M&M lost the part of their case dealing with deducting expenses from their dental business, and the court upheld the penalties on those issues. However, the real estate issue accounted for more than 80% of the deficiency and penalties the IRS was after, so this was a good day in Tax Court for M&M.

Maintaining a contemporaneous log of his real estate activities is what saved M&M’s case on the issue of being a real estate professional. The judge noted in his opinion that M1, “testified credibly and at great length about the logs’ contents; he was able to recall extensive details relating to the entries.” M1 clearly had worked more than 1,000 hours per year on his real estate business.

Imagine, though, that M1 (like most tax payers who want to claim they are real estate professionals) had NOT kept a log of his activities. He would have still worked all those hours, but he would not have been able to meet the burden of proof for it in court. M&M’s passive loss deductions would have been suspended and they would have had to pay more than $300,000 in additional taxes and penalties. That little log book ended up paying M&M more than $100,000 per year from 2010-2012.

It’s not much fun to keep good records like that. Maintaining a log of your activities is tedious and time-consuming. You’d really rather not bother. Until you realize Uncle Sam may be paying you $100,000+ per year to do it. If M1 is still in the real estate business, I’ll bet he smiles a little bit every time he makes an entry in that book. I know I would.