The Tax Court in Brief October 24 – October 30, 2020
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The Week of October 24 – October 30, 2020
Sharma v. Comm’r, T.C. Memo. 2020-147
Short Summary: The taxpayers field a joint federal income tax return for their 2014 tax year. On their return, they claimed a loss of $26,877 from rental real estate activities detailed on Schedule E. The IRS disallowed $20,913 of their claimed $26,877 Schedule E loss deduction, resulting in a deficiency in tax of $5,230. The taxpayers filed a timely petition with the Tax Court.
Key Issue: What portion of the taxpayers’ loss deduction from rental real estate activities claimed on Schedule E is disallowed under I.R.C. § 469(a) and limitations on the deductibility of passive activity losses.
- Based on a proper calculation of the taxpayers’ MAGI under section 469(i)(3)(F), which is $138,071, the taxpayers may claim a loss deduction in the amount of $5,964. The remaining amount of losses is disallowed under the passive activity loss rules.
Key Points of Law:
- Generally, the Commissioner’s determination of a deficiency is presumed correct, and the taxpayer has the burden of proving it correct. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Deductions are a matter of legislative grace, and the burden of showing entitlement to a claimed deduction is on the taxpayer. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992).
- Taxpayers may claim deductions for certain business and investment expenses under sections 162 and 212. However any deduction for a “passive activity loss” for a taxable year is disallowed, and the disallowed loss is carried forward to the next taxable year. See 469(a) and (b). A passive activity loss is the amount by which the aggregate losses from all passive activities for the tax year exceed the aggregate income from all passive activities for such year. Sec. 469(d)(1). A “passive activity” is any activity which involves the conduct of any trade or business in which the taxpayer does not materially participate. Sec. 469(c)(1).
- Rental activities are generally treated as per se passive activities regardless of whether the taxpayer materially participates. 469(c)(2), (4). There are, however, two significant exceptions to this general rule. First, it does not apply to rental activities of taxpayers engaged in certain real property trades or businesses; such activities are instead subject to the material participation requirements of section 469(c)(1). See Sec. 469(c)(7). Second, section 469(i) provides an exemption permitting individuals who actively participate in rental real estate activities to deduct up to $25,000 in annual losses from such rental activities. Sec. 469(i)(1) and (2).
- The $25,000 maximum exemption is subject to a phaseout that reduces the exemption by 50% of the amount by which a taxpayer’s “modified adjusted gross income” (MAGI) for the taxable year exceeds $100,000. See 469(i)(3)(A), (F). Consequently, if a taxpayer’s MAGI is $150,000 or more, the section 469(i) exemption is fully phased out. Spouses who have filed a joint return are treated as a single taxpayer for purposes of the MAGI calculation, and both spouses’ income therefore must be taken into account in calculating their MAGI. Opperwall v. Comm’r, 105 F.3d 666 (9th Cir. 1997); sec. 1.469-1T(j)(1).
- Under section 469(i)(3)(F), for purposes of the section 469(i) exemption, “adjusted gross income shall be determined without regard to” the following items: (1) the taxable portion of Social Security benefits that would be included in gross income under section 86; (2) the exclusion from gross income of amounts received upon redeeming U.S. savings bonds in the circumstances described in section 135; (3) the exclusion from gross income of adoption assistance payments in the circumstances described in section 137; (4) the section 199 deduction for income attributable to domestic production activities; (5) the section 219 deduction for qualified contributions to a retirement plan; (6) the section 221 deduction for education loan interest payments; (7) the section 222 deduction for qualified tuition expenses; and (8) any passive activity loss.
Insight: The Sharma decision serves as a good reminder as to how complex the passive activity loss rules can be under section 469 of the Code. Taxpayers should consult with a tax professional where they are engaged in real estate activities.
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