The textbook case of what goes wrong when tax amateurs jump into real estate

[Bruce D. Kowal]

[This Tax Court case shows what happens when a Real Estate investor has some acquaintance with the lingo, and an incomplete knowledge of the substance of tax law.  This is from three years ago]

Married couple. Both work full-time jobs—tech support and computer specialist.

They also own rental properties. Want to be "real estate professionals" so they can deduct rental losses.

The rules: To qualify as a real estate professional, you must spend more than half your working hours in real estate AND work more than 750 hours per year in real property activities.  Simpler:  you must be "in the business" at least 16 hours weekly.  All 52 weeks. So if you are in rental real estate.  Every weekend.  Eight hours per day.  Got it?

Their claim: We worked 767 hours in 2013 and 407 hours in 2014 on our rental properties. We kept logs to prove it.

Tax Court examines the logs.

The logs don't show which spouse worked which hours. Just combined totals.

The hours are inflated—they counted time "being physically present" at properties, not actually working.

They hired property managers. Ebony Calhoun in 2013. Augusta Partners in 2014. Can't prove they worked more hours than the managers they paid.

Both had full-time jobs. Can't show that more than half their working time was in real estate.

Then the court looks at their deductions.

They claimed depreciation on a Ford Explorer through their LLC. The wife personally owns the car. The LLC doesn't.

They claimed losses on properties in Athens and Snellville through their LLC. They personally own those properties. The LLC doesn't.

They never made the required election to group their rental activities together.

They can't prove their basis in the LLC. Without basis, no loss deductions allowed anyway.

Tax Court ruling:

All rental loss deductions disallowed. Ford Explorer depreciation disallowed. Property losses through LLC disallowed.

[What's likely going on, and this is very common, is commingling of personal and business transactions in ONE bank account. In this case, they likely had a separate LLC bank account and ran personal transactions through them. In addition, the concepts or Basis and At Risk, are beyond most Taxpayers.]

Plus 20% accuracy-related penalties.

Total deficiencies: $24,451 (2013) and $14,440 (2014)

Total penalties: $4,890 (2013) and $2,888 (2014)

The case doesn't say how their returns were prepared. What we know: tax amateurs jumped into real estate without understanding the rules. By the time they got to Tax Court—even with an attorney—it was too late.

Now, many of you think that the chance of an IRS audit is slim.  Maybe.   But, to paraphrase Clint Eastwood, "Do you feel lucky?".  

Further, those of us who are tax professionals, EAs and CPAs, we don't prepare tax returns like this.  

Oh, IRS shares its audit adjustments with States.  So, Georgia will also be assessing a tax deficiency plus interest, plus penalties.

Dunn v. Commissioner, T.C. Memo. 2022-112

Couple Liable for Penalties; Deductions Disallowed