The Tax Court recently held that a mortgage broker was not a real estate professional and therefore was subject to the passive activity loss rules of Sec. 469 (Hickam, T.C. Summ. 2017-66).
During the years at issue, Kurt Hickam brokered real estate mortgages and other loans secured by real estate, both as an independent contractor and as an employee. Hickam was a licensed real estate agent, but he did not operate, develop, redevelop, construct, reconstruct, or rent real estate in brokering mortgages or originating loans. He did, however, manage and maintain various properties owned by himself and family members. Services that Hickam provided for the properties included placing ads, processing applications, inspecting conditions, and overseeing repairs and remodels. He received $6,000 annually for these services but did not keep contemporaneous records of the hours spent.
On his 2011 and 2012 tax returns, Hickam claimed rental real estate loss deductions for the properties. Upon audit, the IRS disagreed and determined that the passive activity loss rules applied, as Hickam was not a real estate professional. He argued to the court that his mortgage brokerage services and his loan origination services should be included for purposes of satisfying the real estate professional test. Additionally, he prepared a noncontemporaneous calendar for each month reflecting time spent on property management, mortgage brokerage services, and loan origination services.
Sec. 469(a) disallows a passive activity loss. Sec. 469(d)(1) defines the term "passive activity loss" as the amount by which the aggregate losses from all passive activities exceed the aggregate income from all passive activities for the year. Under Sec. 469(c)(1)(A), the term "passive activity" means any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. With the exception of real estate professionals described in Sec. 469(c)(7), Secs. 469(c)(2) and (c)(4) together consider any rental activity a passive activity, even if the taxpayer materially participates in it.
Sec. 469(c)(7)(B) provides two tests, both of which must be met, for a taxpayer to be classified as a real estate professional. The first test is met if more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates. The second test is met if the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates. The requirements of Sec. 469(c)(7)(B) can be met only by a taxpayer who materially participates in a real property trade or business. Sec. 469(c)(7)(C) defines the term "real property trade or business" as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
The court held that Hickam's mortgage brokerage services and his loan origination services did not constitute real property trades or businesses under Sec. 469(c)(7)(C). While the brokered loans were secured by real property, Hickam's services did not involve operating the real properties. Further, the court held that, while his mortgage brokerage services were a brokerage trade or business, they were not a real property brokerage trade or business, as he did not broker real estate, only loans.
Ever since the enactment of the real estate professional rules, the IRS and taxpayers have struggled with what constitutes a real property trade or business within the 11 enumerated items in Sec. 469(c)(7)(C). The IRS clearly has authority to promulgate regulatory guidance to define these 11 terms but has chosen to deal with the definitional issues in examinations and in the courts.
For a detailed discussion of the issues in this area, see "Tax Clinic: Court Rules Mortgage Broker Is Not Real Estate Professional, Passive Activity Rules Apply," in the January 2018 issue of The Tax Adviser.
— David Kirk, CPA, J.D., LL.M.
The Tax Adviser is the AICPA's monthly journal of tax planning, trends, and techniques.
Also in the January issue:
- A discussion of self-certification and the 60-day rollover rule.
- An introduction to U.S. equity crowdfunding.
- An analysis of IRS transcripts of account.
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