IRC section 469 generally disallows a deduction in the current year for the amount by which taxpayers’ losses from passive activities exceed their passive income; instead, such losses can be carried forward and offset against passive income in future years. Passive activities include trade or business interests in which taxpayers do not materially participate as well as rental activities in which they receive payments for the use of tangible property. When owners provide extraordinary personal services to tenants, the venture is not considered a rental activity as long as the taxpayer “materially participates” by devoting more than 500 hours to it.
Rehab Assaf was an attorney and partner in a law firm. Her husband, a medical doctor, was a full-time professor who also provided consulting services to attorneys and HMOs. The Assafs each owned 50% of AGI Consulting, a limited liability company, which in turn owned a building it rented to attorneys, providing them with three services: office space, legal support services and consulting services. The legal support services included human resources (a paralegal, a legal intern, a law clerk and secretarial and administrative support) and physical resources (a law library, conference room and computer). Mrs. Assaf was the sole manager of AGI’s rental activities while her husband provided the consulting services.
AGI reported losses of approximately $34,000 in 1999 and 2000, which the Assafs reported on their schedule E. The IRS disallowed these losses claiming the rental activities were passive and Mrs. Assaf could not have spent enough time related to AGI to have materially participated in the business. The taxpayers petitioned the Tax Court for relief arguing that AGI was not a rental activity because the extraordinary service exception applied and Mrs. Assaf had materially participated in the management of AGI.
Result. For the taxpayers. The court referred to regulations section 1.469-1T(e)(3)(ii)(c), which provides guidance related to the interpretation of extraordinary personal services. It said that to qualify for the extraordinary service exception, the use of the rental building by AGI’s tenants must be incidental to the receipt of the other services provided. The Tax Court cited a prior case, Welch v. Commissioner, TC Memo 1998-310, in which the court had determined customers leased property mainly because of the extraordinary services provided by the owner. In Assaf, the Tax Court heard testimony from tenants who said they chose AGI because of the special services provided. The court concluded the rental of the office space was incidental to the services provided by AGI and the operations of AGI therefore were not a rental activity.
The IRS also argued that Mrs. Assaf could not have devoted enough time to AGI to satisfy the material participation test since she had over $175,000 of income from her law practice in each of the years in question. While Mrs. Assaf had not kept contemporaneous logs or records documenting the time she spent managing AGI, she estimated she had devoted approximately 1,300 hours in each of the years in question.
The IRS argued that since the estimate had been made after the fact it was neither reliable nor reasonable. But the court found her estimate acceptable, saying contemporaneous records are not required when reliable, objective evidence and testimony are available. This evidence consisted of Mrs. Assaf’s testimony, confirmed by others, that the activities performed by her had not changed since the tax year in question.
If a taxpayer can show that tenants’ use of rental property is incidental to other services provided to them, the taxpayer can qualify for the “extraordinary personal services” exception. The Tax Court, in this case, has provided some guidance on how to apply the exception. A crucial factor used by the court was whether the services provided to the tenants were the main reason that the tenants had chosen the taxpayers’ office space.
Assaf F. Al Assaf and Rehab Assaf v. Commissioner, TC Memo 2005-14.
Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.