Real Estate Is Taxing

Join me as I dive into two real estate focused Tax Court cases from summer of 2024. There's always something interesting to be learned when it comes to court cases. 

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TC Summary 2024-17

TC Summary 2024-13

[00:00:00] Welcome to Real Estate is Taxing, where we talk about all things real estate tax, and break down complex concepts into understandable, entertaining tax topics. My name is Natalie Kolodij, I'm your host, and I am so excited that you've decided to join me.

[00:00:23] Hello. Hello everyone. Welcome to this week's episode. This summer has been a pretty good summer for tax court cases. And what I mean is that there have just been several that I specifically have enjoyed and thought were interesting. And that's because there have been a handful that relate to real estate. 

[00:00:45] 

[00:00:46] Now I love anything court related. I love reading true crime books. I love listening to the podcast. So for me, Reading tax court cases is extra exciting. But even [00:01:00] if you do not find that as cool as I do. These are still something that you should hold at least a little bit of interest in. The tax code itself is very rarely black and white. 

[00:01:12] There's a lot of room for interpretation. There's a whole lot of guidance and nuance that happens after the code is written. And the tax court results are really just one of those pieces of guidance. Reading these court cases. Really does give us fantastic insight to the way the courts have been leaning on some of these topics that are in that gray area. And when it comes to real estate, there's plenty of gray area that we love playing in with the tax code. So getting these more recent kind of thoughts from the tax court. Getting this feedback, seeing how they're viewing things. 

[00:01:55] This is invaluable. What I have for you guys today. [00:02:00] Is two court cases that are both tax court summary opinions from this summer. So these are super recent from July and August. And both are related to real estate. 

[00:02:11] The first case that I want to walk you guys through is from last month, this came out August 20, 24. This is TC summary, 2024 dash 17. Eason V commissioner. So this case was interesting because it deals with a topic that comes up pretty frequently when it comes to real estate in two different capacities. The first one being, if you pay for one of those 40, 50, $60,000 real estate guru courses, is it deductible? 

[00:02:45] And when is, or isn't it. And the other part of the question being, if you are new in real estate. When does your business actually begin? When are you open for business where you can start writing [00:03:00] off? All of your costs that are incurred. So those were the two big questions that came up in this case. 

[00:03:08] So this summary opinion relates to a couple who owned two rentals in 2016. One of them, they maintained as a rental. The second rental property they had sold by June of 2016. So at this point, they've got a little bit of real estate experience. They just actively got rid of half of their real estate business that existed, so to speak. 

[00:03:33] So they've got one rental left. 

[00:03:35] That same year. The taxpayer in this case. Lost his job. Close to the beginning of the year, the taxpayer lost his job. And the couple started looking into other ways they could supplement their income and other opportunities to help make up. For that last paycheck, they were used to getting. And one of the things they came across was real estate investing. So [00:04:00] they were already a little bit familiar with it and they had some experience with rentals, but they stumbled across an ad for a real estate course or courses that you could take. That would teach you how to invest presumably. In some capacity. The court case does not go into the details. Of exactly what was covered in that course or those courses. But what it does say is that the taxpayer and the spouse decided to invest in this And they spend $41,934 on two different courses from this same real estate. Uh, quote, education provider. So once they bought these courses, The couple, then went on to set up an S corporation. So they established an S Corp in July of 2016. And they got some business cards. They got some custom branded stationary. [00:05:00] But outside of that, Nothing else really happened. So there was no additional purchases of real estate. There were no proven efforts at marketing. For a real estate. 

[00:05:14] There was no proven efforts at advertising that they were in the market to buy real estate. Really not a whole lot else happened after they set up this S corporation and bought some business cards. Also worth noting. Is that by 2018. So within a year and a half from when they purchased these large expensive courses. The company through whom they had bought the courses. Went out of business. So another piece to this specific case that was taken into account by the tax court. Was the fact that this couple did anticipate having this ongoing support and resources. And all of this training and the moon and the sun and [00:06:00] everything else gurus promise you when you give them $40,000. And by 2018. None of it was there. 

[00:06:07] It had all disappeared. The company went under and they were now on their own. 

[00:06:12] So the year in question. For this couple's court case is 2016. So 2016 is the year when, as a recap, they had one rental property. They had sold off their other rental. Husband lost his job and they paid 40,000 plus dollars to accompany for real estate education. They then set up an S corporation, got some business cards and stationary. And that was the extent of the business operations. 

[00:06:44] in this case, there were a few key considerations. That were looked at. The first consideration. Is. Under code section 1 62. When is the taxpayer entitled to [00:07:00] deduct? An expense as a business expense that is ordinary and necessary. Like when is it rightfully able to be deducted? And a part of the wording to that code section. Is that it relates to ordinary or necessary expenses paid or incurred? During a tax year in quote, carrying on any trader business. Now a lot of businesses do not make money for their first few years. 

[00:07:29] That's not uncommon. A lot of businesses lose lots of money for multiple years that does not make or break whether or not someone is operating a business. However, in this case. There was all of the expense with none of the income, but also none of the proven effort to generate income. And none of the provable attempts. To actually continue to operate a business after buying the course, setting up the company, buying some [00:08:00] business cards that was the end of their effort. So for 2016, This couple reported over $40,000 of expenses as deductible business expenses. But when the court went back and looked, they really had no proof. That a good faith attempt was made. To actually run or operate or carry on a trader business. Part of the reason why. Is that it was never clearly defined what this couple's business was. 

[00:08:35] So this makes things a lot trickier, right? If someone is opening a bakery, it's pretty clear that as of the time their doors are open and they've got a case filled with macaroons. They are open as a bakery. That is what they're offering to the public. We had no defining information on what this couple's business was, except for something related to real [00:09:00] estate. 

[00:09:00] the only. Defining information, the couple gave about their S-corp and why it was set up and what they were going to use it for is that they said that they quote, formed it to provide advice and guidance to real estate owners and investors. The court went on to note that although the specific services that they intended to offer were unclear. That, whatever it was, they were going to offer.did not require, or they had not applied for, or received any kind of state or local or federal licenses, business license, et cetera. So just a quick recap. We've got a couple who've owned, two rental properties. 

[00:09:45] They've currently got one. They just paid $40,000 for a course on real estate. They set up an S-corp literally the same month that they paid for that course. And then told the court, the purpose [00:10:00] of that S corporation was to provide guidance and advice to real estate owners and investors. So, this is just a side note, little sidebar here. That there are more people doing this. Then I think a lot of people realize. This is a couple who paid for a real estate course, and then we're turning around and what their stated. Plan was for their corporation, was to teach other real estate investors. And guide them on their real estate. The only experience they had was two rentals and having just paid $40,000 to someone else.So an interesting overlap that just adds a little bit of warning to be careful and actually look into the background. Of people offering these courses and what they are benefiting from it. And if them. Offering this course and selling you this course is making [00:11:00] them more money than their actual real estate dealings, or if they don't actually have experience in these areas of real estate. And just be, just be careful. So at the end of the day, The court looked at all of these pieces of information and they determined that this couple did not ever open a business. They had never put forth a valid attempt. Two. Really operate any kind of business. 

[00:11:29] There was no continuing ongoing operations. It never even really started. There was never any defined factor of what it was except for providing general advice and guidance to others. But they hadn't marketed that or tried to sell that or anything else. So on this TC summary, 20, 24 17, the court disallowed, all of that expense. Because it wasn't considered a valid business expense. So the [00:12:00] moral of this case and this story. Is that just paying for something to learn how to do something or to learn about something does not automatically mean it will be tax deductible. Especially if you either have not. Started a business in that industry. 

[00:12:18] And this is related to it. Or if you never do, if you never get to that point, it's even less likely that it's going to be deductible. So just be cautious before spending large amounts. On potential businesses, right? On something that you are hoping to open a business doing, because it might not be deductible. And the secondary caution takeaway is be careful of who you are paying for education and advising and look into their background because these guys were going to sell education. The same month they had just paid to learn the information. So just be [00:13:00] careful. 

[00:13:00] The next case from this summer. I really liked reading. And this was from July of 2024. This is TC opinion, 2024 dash 13. And this is for this and more V commissioner. This case related to. Short-term rental. So here. Is the interesting dynamic of this case. Is that it was argued. Based on the premise of real estate professional status. 

[00:13:30] And it probably shouldn't have been. So in this case for a dozen more married, couple decide in 2020 that they are building a carriage house. In the back of their property. They had actually obtained permits for this a couple of years earlier, but 2020 is the year that they finally get to move forward with this project. And start constructing this carriage house. Now, both the taxpayer [00:14:00] and the spouse work, full-time at least 40 hour a week jobs. The taxpayer makes just under 80,000 a year. 

[00:14:07] The spouse makes just over 80,000 a year. So this puts their overall income. Well above the amount where you can deduct some level of passive losses. Unless you're a real estate professional. Or unless you meet the short-term rental loophole. So during 2020. They start building this carriage house and the taxpayer spent a lot of time doing a lot of the work himself.So he would work full time and then per his testimony, he would spend all of his evenings and weekends. Working on this carriage house.He did also say that he hired out any of the work that he wasn't able to do himself. But he said he spent well over 2,500 hours that year. Working on and to [00:15:00] building this carriage house. So here's where things go sideways. So this couple completes this carriage house in 2020, they put it in service in October as a short-term rental. And for the 2020 tax year, they deduct a schedule II loss of just over $22,000. So. Their return gets looked at. It goes under audit and ends up in court. 

[00:15:30] And here were the key things that were considered. The first being, if this loss was valid to be deducted. But the only consideration was, if this loss was able to be deductible as a non-passive loss. Based on the premise of the taxpayer being a qualified real estate professional. Meaning they spend more than half of their [00:16:00] time. On this real property trader business. The court felt that was not super likely. Even though the taxpayer testified, he spent more than 2,500 hours on this carriage house. 

[00:16:14] He had no proof other than this testimony. And they just didn't find it super likely. That he was working even more on this one carriage house and building this property. Then he was at his full-time job. In addition to this. In October when they put this property in service as a short-term rental, they immediately listed it with a management company. And that management company handled everything. the cleaning, the tenant screening, all of it. So not only was their question to the amount of hours spent during the build. But then once it was operational, they immediately handed off all of the day-to-day management and time to [00:17:00] someone else.So in this case, this loss was determined to be passive. 

[00:17:06] And the deductability of that loss was disallowed. Due to their income level. Okay. Here's what's really interesting to me with this. We don't have all of the details. But based on what we know. This was a short-term rental and this taxpayer did spend a lot of time on this property. Now, once it wasn't service, they were no longer managing it. But I think it's incredibly interesting. That the other options for it being non passive, weren't brought up. I want everyone to bookmark this case. And the next time you have a CPA or tax professional. When you talk to them. And they tell you that rental losses are going to be passive, unless someone's a real estate professional. Or unless the [00:18:00] rental goes on, schedule C. I want you to send them this case. Because this is what happens. When you try to take advantage of something in real estate when it comes to the tax code, but either you or who you're working with. I don't know what they're doing. This is really nuanced. 

[00:18:21] There are more than one ways for a rental to be non passive. And in this case, we don't know the average length of stay. We know it was a short-term rental and we know it was only rented for a few months. So if it turned out that the average guest stay was seven days or less, And if it could be proved that even with management, this taxpayer still met material participation through one of the rules. I feel like they would have had a much better chance. Of making that argument to be able to deduct this loss in tax court, then making the argument for real estate [00:19:00] professional status. But that's not the argument that the taxpayer made. They argued that they qualified for reps. They were not aware of this short-term rental loophole or if they were, they didn't think it would be the better route. 

[00:19:16] I don't know. But for me looking at this as an outsider, it was incredibly frustrating because the first thought I had was there was likely a much stronger argument for them to be able to deduct that loss. So, again, this was TC summary opinion, 2024 dash 13. And this is from July. 

[00:19:37] This was just put out. And this is related to a 2020 tax year return. So this is all very recent. And wasn't presented in a way that was most likely going to be in the best interest of getting to maintain that non-passive rental loss. 

[00:19:56] Like I said, Lots of interesting [00:20:00] tax court cases this summer, or at least to me. So I hope you guys found this somewhat interesting or maybe learn something new from these cases. I will link to both of these in the show notes. If you want to read over them yourself. And again, I can't reiterate this enough. 

[00:20:18] Reading through these court cases is such a good way to learn. More of the, between the lines guidance. That relates to tax. It is not all black and white. And what is on the IRS website is only. An interpretation of the actual tax law. And it's not even substantial authority that you could bring into a court case like this and use to defend yourself. 

[00:20:45] You need to know the law, you need to know the related other court cases that you can lean on for precedent. So super interesting area to familiarize yourself with, again, I'll link below. If you guys have questions, pop into the [00:21:00] Facebook groups, those are linked below as well. So as always, if you've enjoyed this episode or if you know someone who you think would enjoy this, please share it with them. And. I will talk to you guys next week.Mhm.