Active Participation In A Rental

[TAXBILLY]

I had a Schedule E audit a few weeks ago. The auditor is disallowing the rental loss because she says my client did not actively participate because he had a management company handle the day to day problems such as minor repairs and paymentof taxes and mortgage. I pointed out that the taxpayer did not give carte blanche decision making to the management company such as, for example, a decision to put on a new roof. I also pointed out that the taxpayer did make trips (20 miles away) to inspect the property for damage from hurricanes. Taxpayer also did some work in the rental when one renter moved out, painting the interior and preparing the floor for a tile installation. This does not seem to be enough for the auditor so I'm going to have to take this to appeal.

My question is does anyone know where I can get a good explanation of the active participation rules and possibly some court case cites?

I have looked at the code section IRC469 as well as the Internal Revenue Auditor's Manual.

Any and all suggestions are welcome.

taxbilly

[Brad Imsdahl]

TTB, page 7-12 says, "Active participation standards are met if the taxpayer (or taxpayer's spouse) participates in management of the rental property in a significant and bona fide sense. For example, management decisions such as approving new tenants, deciding on rental terms, approving expenditures, and similar decisions meet active participation standards."

The problem with hiring a management company to find tenants and manage the property is often under the terms of the management arrangement, the landlord turns over these decisions to the management company. That is why you hire a management company – to take care of these day to day decisions. The active participation standards are not met simply because major repair work needs the landlord’s approval, or the landlord spends 40 hours per year doing token repair work. It has to be the day to day operation that the landlord is involved with.

If you want to count time spent repairing the property and so forth, you have to meet the Real Estate Professional rules (TTB page 7-13), which require more than 750 hours of service per year. Material participation rules (such as spending more than 500 hours per year, or more than 100 hours and nobody else spent more) do not apply to rental activities (TTB 7-9).

[jainen]

Day-to-day operation

>>It has to be the day to day operation that the landlord is involved with.<<

Day-to-day operation may be too high a standard for active participation in the case of rental real estate, even though it is important in farming and other activities. "Significant and bona fide" should mean less than "substantial."

The original law was the 1986 Tax Relief Act. Court rulings since then haven't generally been very favorable to taxpayers, and anyway it is always hard to identify your own situation with exactly what a court ruled on. For example, in T.C. Memo 1998-112 the court wasn't impressed that the taxpayer had been involved in the decision to hire the management company. It also reminded us that the taxpayer has to come up with more than just theories and promises--real evidence of actively participating is required.

The tax code left it up to the IRS to make the interpretation but it helps to review what Congress had in mind back then. Several courts quote this "legislative history" although in itself it doesn't have a lot of authority. The committee report said,

"The difference between active participation and material participation is that the former can be satisfied without regular, continuous, and substantial involvement in operations, so long as the taxpayer participates, e.g., in the making of management decisions or arranging for others to provide services (such as repairs), in a significant and bona fide sense. Management decisions that are relevant in this context include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions.

"Thus, for example, a taxpayer who owns and rents out an apartment that formerly was his primary residence, or that he uses as a part-time vacation home, may be treated as actively participating even if he hires a rental agent and others provide services such as repairs. So long as the taxpayer participates in the manner described above, a lack of participation in operations does not lead to the denial of relief."

[cpadan]

There is a tax court case, MADLER 3//18/1998 which deals with that issue. Taxpayer lost, it involved a condo. Court was looking for evidence such as personally approving of tenants, setting rental tems, approving of expenditures for repairs ect.

Try a search for "actively participate" on the tax court site.

Good luck, Dan

[Brad Imsdahl]

I agree. When you use a management service, have it set up where they find the tenants, but you have to look at the paperwork and sign off on the new tenant before giving them the keys. As for cleaning and repairs, have the management company give you a recommendation of what needs to be done, but your signature is required before any work can begin. You have to be involved in the management of the rental unit. Simply giving the management company approval to manage the property is not enough.