Investors dealt tax blow over depreciation deduction

Ulysses Lee was a full-time IRS tax examiner. His brother,Kai, worked as a full-time professor of radiology. Together, they are partnersin Lee Brothers Investments, which owns a rental house, a five-unit apartmentbuilding and another small apartment building. Each investor also owns severalrental properties individually.

On their income tax returns, the brothers claimed passiveactivity 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 Code469(c)(7)(B), they claimed each brother performed more than 750 hours of realestate professional services annually (about 14 hours per week) and more thanone-half of their personal services are performed operating their properties.

On their income tax returns, the brothers depreciated theirproperties on a 10-year depreciation basis, rather than the 27.5 years requiredby IRS straight-line depreciation rules. When the IRS denied the accelerateddepreciation deductions, and denied the unlimited real estate tax lossesagainst 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 thebrothers to use accelerated depreciation and to qualify as real estateprofessionals?

The judge said no!

There is no question Ulysses Lee and Kai Lee spentconsiderable time involved with their real estate investment properties, thejudge began. They qualify as “material participants” in their realestate ventures, he opined.

However, their “ballpark guesstimate” of the timespent on different real estate activities were not contemporaneous logs, thejudge continued. “We do not find the logs, or the testimony accompanyingthem, credible,” he added.

The judge found 280 hours to close the books on theirinvestments to complete their tax returns, 24 hours to replace miniblinds, 186hours to show vacant apartments, and 200 hours answering phone calls fromprospective tenants over a two-year period to be excessive.

“The exaggeration of their logs of real estate work wasmatched by understatements of time spent at their full-time jobs,” thejudge noted. In addition to the extra tax due, the judge assessed penalties fornegligence because neither taxpayer could be considered a real estateprofessional working at least 750 hours annually.

Based on the 2006 U.S. Tax Court decision in Kai andUlysses Lee v. Commissioner, 92 Tax Court Memo 2006-193.

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Copyright 2006 Inman News

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