Ulysses Lee was a full-time IRS tax examiner. His brother, Kai, worked as a full-time professor of radiology. Together, they are partners in Lee Brothers Investments, which owns a rental house, a five-unit apartment building and another small apartment building. Each investor also owns several rental properties individually.
On their income tax returns, the brothers claimed passive activity tax loss deductions, mostly from depreciation of their properties, against their substantial ordinary income from their full-time jobs.
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Upon audit by the IRS, using Internal Revenue Code 469(c)(7)(B), they claimed each brother performed more than 750 hours of real estate professional services annually (about 14 hours per week) and more than one-half of their personal services are performed operating their properties.
On their income tax returns, the brothers depreciated their properties on a 10-year depreciation basis, rather than the 27.5 years required by IRS straight-line depreciation rules. When the IRS denied the accelerated depreciation deductions, and denied the unlimited real estate tax losses against the ordinary job incomes, the brothers took their dispute to the U.S. Tax Court.
If you were the U.S. Tax Court judge would you allow the brothers to use accelerated depreciation and to qualify as real estate professionals?
The judge said no!
There is no question Ulysses Lee and Kai Lee spent considerable time involved with their real estate investment properties, the judge began. They qualify as “material participants” in their real estate ventures, he opined.
However, their “ballpark guesstimate” of the time spent on different real estate activities were not contemporaneous logs, the judge continued. “We do not find the logs, or the testimony accompanying them, credible,” he added.
The judge found 280 hours to close the books on their investments to complete their tax returns, 24 hours to replace miniblinds, 186 hours to show vacant apartments, and 200 hours answering phone calls from prospective tenants over a two-year period to be excessive.
“The exaggeration of their logs of real estate work was matched by understatements of time spent at their full-time jobs,” the judge noted. In addition to the extra tax due, the judge assessed penalties for negligence because neither taxpayer could be considered a real estate professional working at least 750 hours annually.
Based on the 2006 U.S. Tax Court decision in Kai and Ulysses Lee v. Commissioner, 92 Tax Court Memo 2006-193.
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