On this episode of Adam Talks, tax attorney and IRA Financial’s founder, Adam Bergman, Esq., discusses a recent Tax Court case centered around the importance of understanding the passive activity loss rules under Section 469 of the Code.
New Case Every Real Estate Investor Must Know
This episode of Adam Talks, titled “New Case Every Real Estate Investor Must Know,” hosted by tax attorney Adam Bergman, discusses an important Tax Court case issued on July 11, 2024. The case, Timothy L. Foradis and Jessica L. Moore versus the IRS, highlights the loss limitation and passive activity rules that affect real estate investors. Bergman emphasizes that not all real estate deductions can be used to offset active income due to passive activity loss rules under Section 469 and at-risk rules under Section 465 of the Tax Code. These rules were introduced to prevent tax shelters prevalent in the 1980s.
The facts of the case involve Mr. Foradis and Ms. Moore, who built a property called the Carriage House and incurred significant losses. They attempted to use these losses to offset their active income but were issued a notice of deficiency by the IRS, disallowing $22,376 of rental real estate loss deductions. The core issue was whether the taxpayers materially participated in the real estate activities, a requirement to avoid passive activity loss limitations.
To qualify as a real estate professional and have passive losses treated as active, two tests must be satisfied: more than half of the personal services performed by the taxpayer must be in real property trades or businesses, and the taxpayer must perform more than 750 hours of services during the taxable year. In this case, Mr. Foradis claimed to have spent 2,500 hours on the Carriage House, in addition to his full-time job, but could not provide credible evidence to support this.
The Tax Court found it implausible that Mr. Foradis could work full-time and also spend the claimed hours on the real estate project. Without adequate records to prove his involvement, he failed the first test, and thus the court did not need to consider the second test of the 750-hour requirement. This case underlines the importance of maintaining thorough records to substantiate claims of material participation in real estate activities.
Bergman points out that the burden of proof lies with the taxpayer, and mere assertions are insufficient. Evidence such as witnesses, clocking in and out, or GPS data could strengthen a taxpayer’s case. He also addresses a common misconception among real estate investors regarding the ability to offset active income with passive losses, highlighting the necessity of understanding passive activity loss rules.
In conclusion, Bergman underscores the importance of understanding the passive activity loss rules for real estate investors. He also suggests that using an IRA for real estate investments may provide tax advantages, as it circumvents some of the complications associated with passive activity losses. The Foradis case serves as a cautionary tale, showing that without proper documentation, taxpayers cannot rely on passive losses to reduce active income.
