In Kurt Hickam et ux. v. Commissioner, the Tax Court held that a mortgage broker is not a real estate professional and is subject to the passive activity loss rules of Section 469.

Facts

During the years at issue, Mr. Hickam brokered real estate mortgages and other loans secured by real estate, both as an independent contractor and as an employee. Mr. Hickam was a licensed real estate agent, but did not operate, develop, redevelop, construct, reconstruct, or rent real estate in brokering mortgages or originating loans. Mr. Hickman did however manage and maintain three rental real estate properties, two single family homes and a small apartment building, owned by himself and family members. Services provided by Mr. Hickman for the properties included placing ads, processing applications, inspecting conditions, and overseeing repairs and remodels. Mr. Hickman received $6,000 annually for these services, but did not keep contemporaneous records of the hours spent.

On his 2011 and 2012 tax returns, Mr. Hickman claimed rental real estate loss deductions of $ 47,730 and $ 48,945 for the three properties. Upon audit, the IRS disagreed and determined that the passive activity loss rules apply, as Mr. Hickman was not a real estate professional. Mr. Hickam 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 non-contemporaneous calendar for each month reflecting time spent on property management, mortgage brokerage services and loan origination services.

Law

Section 469(a) disallows a passive activity loss. Section 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 Section 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 Section 469(c)(7), Section 469(c)(2) and (c)(4) together consider any rental activity a passive activity, even if the taxpayer materially participates in the activity.

Section 469(c)(7)(B) provides two tests, both of which must be met, in order 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 is 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 Section 469(c)(7)(B) can be met only by a taxpayer who materially participates in a "real property trade or business." Section 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.

Holding

The Court held that Mr. Hickam's mortgage brokerage services and his loan origination services did not constitute real property trades or businesses for purposes of Section 469(c)(7)(C). While the loans brokered were secured by real property, Mr. Hickam's services did not involve operating the real properties. Further, the Court held that, while Mr. Hickam's 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.

Regarding the time spent in rental property management, the Court held that Mr. Hickam failed to prove how much time he spent on the activity during 2011 and 2012. The Court noted that the records were prepared well after the years at issue with ballpark estimates of time and the descriptions were vague and non-descriptive. Further, Mr. Hickman did not present as evidence at trial the leases, bank statements, checkbooks, bills and receipts used to reconstruct the amount of time spent.

Considering all of Mr. Hickman's activities, the Court held that he did not satisfy the two Section 469(c)(7)(B) tests to be treated as a real estate professional for 2011 or 2012 and thus may not deduct the rental real estate losses under the real estate professional exception. While the Court found that Mr. Hickman substantially understated his income and failed to maintain adequate records to substantiate the rental real estate loss, he did act reasonably and in good faith and is thus not liable for a Section 6662(a) accuracy-related penalty for 2011 or 2012.

Although the case is only a summary opinion, and the taxpayer was representing himself, the opinion lines up with the IRS's previous opinion on the matter found in CCA 201504010. The Court, like the IRS in the CCA, drew its conclusion from the cannons of statutory interpretation after reflecting on the tangled legislative history of Section 469(c)(7) enactment in the early 1990s. Although Congress initially included "finance operations" in the list of qualifying real property trade or business activities in an earlier, unenacted 1989 version of what would become Section 469(c), "finance operations" (along with "appraisal") was removed from the 1993 enacted version. The Court concluded that Congress did not intend for financing activities to constitute a real property trade or business and that financing activities should not be included in the definition of "real property brokerage."

Implications

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 Section 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 exam and in the courts.

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