Table Of Contents
In this episode, Brandon and Thomas discuss the definition of "individual" for the purposes of qualifying for one of the material participation tests.
This episode is sponsored by Landlord Studio and the 2022 Tax & Legal Summit.
Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.
Thomas Castelli 0:00
You're now listening to the real estate CPA podcast. Your source for all things real estate, accounting
Brandon Hall 0:05
and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.
Thomas Castelli 0:29
Hey everyone, thanks for tuning in to this episode of The Real Estate CPA podcast your host Brandon Hall and Thomas Castelli here and today's episode, we're going to discuss what the definition of individual means for the purposes of qualifying for one of the material participation tests is going to be super important if you're a short term rental investor, or perhaps if you're a real estate professional and trying to use the third material participation test, which basically includes spending more than 100 hours on the activity and no one other individual spends more time than you. So we're going to go ahead and break down what that term means. And we're gonna go ahead and get started. But before we do, if you're doing yourself landlord managing rental properties landlord studio is made for you. The software helps landlords simplify income and expense tracking. With their easy to use app, you can digitize receipts, record income and expenses in real time and generate reports and even manage leases and tenants plus landlord Studio makes late rental payments and bank visits a problem of the past with secure online rent collection, get the rent paid directly to your bank account. And you can even automate rent reminder emails and late payment fees. Landlord studio is also the best way to stay tax compliant, they offer a range of financial reports including Schedule II and supplier expense reports designed for tax time, you can learn more about landlord studio and start your 14 day free trial at landlord studio.com/cpa. And use the coupon code real estate CPA at checkout to get 25% off your plan. Again, that's landlord studio.com/cpa and use the code real estate CPA to get 25% off your plan today. So for a lot of people out there, if you're a short term rental owner, you're trying to turn your losses non passive, you're going to need to meet one of the seven material participation tests. And one of the most viable tests out there for short term rental investors will be the third material participation test which states an individual participates in the activity for more than 100 hours during the taxable year. And such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual. So basically what this is saying here is that you're spending more than 100 hours and no one else is spending more than you. Alright, and the question comes down to big debate is what does the term individual mean? Does it individual mean one human being like me speaking and you listening to this? Or is it referring to an entire company. And this confusion really stems due to the word person in a tax code are often being referred to as an individual, a trust a partnership, or corporation? So sometimes, you know, in this world of complicated tax code language, it's easy for professionals and investors to get really confused on what these words mean. And sometimes I err on the side of caution. So there's been just in the real estate investment community in the short term rental community, there's been a lot of debate on what that word individual means. And I believe I have overwhelming amount of evidence to conclude that the term individual means one human being.
Brandon Hall 3:37
And that's that's big time. News, right? I mean, not news. And it's not new news. It's been there for a long time, it's just that you've not discovered it, and I missed it, I thought an individual, I was still going to be a company, right? If I'm a short term rental owner, and I own a beach home, and I've got a property management company doing work on my beach home, then I have to outperform them 100 hours and more than the company in order to materially participate in my beach home activity, or, you know, cleaners are a good example, I've hired a cleaning company. So it's 100 hours and more than the cleaning company. But Tom's research here tells us that that is incorrect. It is per person. So Tom, in theory, then well walk us through your research. But then what I want to know is that in theory, and I'm not suggesting that anybody do this because we are CPAs, but not your CPA, and we don't know your facts and circumstances to check with your CPA before you do anything along these lines. But in theory, could I hire a cleaning company that cycles out the individual cleaners who are cleaning my rental property and therefore the 100 hours and more than any one other individual is easier to achieve? Yes, in
Thomas Castelli 4:50
theory, you could absolutely do that. That's what the research has showed that the term individual refers to one human being so if you did hire one cleaning company, and They did rotate out their cleaners and you had multiple individuals meaning human beings cleaning your property, each of their hours is separate for this test. So if you spent 101 hours in cleaner, a, let's call them cleaner, a spent 50 hours, well, they spent less than you and you're going to qualify this test. And if a cleaner be spent 75 hours, they also spent less than you. And we're not aggregating these together. So we're not saying even if they're in
Brandon Hall 5:25
the same company, so So collectively, they've spent 125 hours correct. But based on your research, you only have to outperform the highest individual or whatever. Yes, guess what the 75 hours is what you have to outperform what you would outperform anyway, because you've got to hit 100 hours.
Thomas Castelli 5:42
Correct. And one of the things that actually someone pointed out to me in the Facebook group, is that the IRS defines this test slightly different, then the way the IRC has it worded, the IRS says that the individuals meaning your participation in the activity is not less than the participation of any other individual, meaning it can be equal to not less. And then in the tax code, it's and then the IRS says that it is at least that is least as much as another individual. So you have to spend more than 100 hours, but it can be equal, some other individual can spend equal amount to you, but they can't spend more than you basically. So to be equal to calories all day
Brandon Hall 6:27
long. There you go. Yeah, well, tell us about this research man. Where do we find this overwhelming support for the fact that it's an individual and not a company?
Thomas Castelli 6:37
Alright, when you look under reg section 1.4 69 Dash five t which is where you'll find the material participation tests, you'll find the definition of individual is an individual and is not an SBU. Then if you look into reg section 1.989 A dash one, they defined SBU which is a qualified business unit. And SBU is a corporation partnership, estate and trust. They are all SBU is but individuals are not SVU. They say that, so they're saying okay, the definition of an individual is an individual and an individual is not an SBU meaning. It's not a corporation, partnership, estate or trust. So right there, in my book, that's a case close it's defining individual is not these other things. But we're going to take a step further, if you look into the examples under Section 1.4 69 Dash five t, what you'll find is all the examples are written to indicate that they're referring to the individual being a human being, just to give one of the examples that are in the examples. It says a married individual file a separate return, right? So a married individual, corporations, partnerships, other entities don't get married, they might get merged, or they might get acquired, but they're not getting married. That's not the typical language you'll find in the tax code. Human beings do get married. Okay? So right, there's just another piece of evidence when you look at the direct reg section that contains the material participation tests, all the examples, when they say the word individual, indicate that it's a human being. So that's just my second piece of evidence. But then my last piece of evidence that I have is that under Section 7701, a 14 it defines a taxpayer as any person quote unquote, subject to internal revenue tax, and then section 7701. A one defines a person to include an individual a trust, a state of partnership, and a corporation. So this is further indicating that when the term individual is used within the tax code, they are referring to one human being, but when they refer to a person, a person can include one human being a trust, estate, partnership, or corporation. So that's my last piece of evidence I want to put forth on this topic, but those three in combined have convinced me that this is the word term individual verse to one human being. Now we're gonna take a quick break to hear a word from our sponsors. Hey, everyone, we want to let you know that the real estate CPA will be hosting the third annual tax and legal summit for real estate investors coming up on Saturday, February 26, and Sunday, February 27 2022. At this event, you'll learn about lucrative tax and asset protection strategies from the top tax and legal experts in the industry strategies include the real estate professional status, the short term rental loophole, passive losses, Cost Segregation studies, 1031 exchanges, self directed retirement accounts, entity structuring estate planning, and so much more. Don't miss this incredible event designed to save you 1000s in taxes and help protect the assets and wealth you work so hard to build head on over to WW dot tax and legal summit.com to grab your free tickets today. Again, it's WW dot tax legal summit.com to grab your free tickets today. Well the tax lien If somebody is free to attend, we will have six exclusive sessions available to VIP ticket holders. And you can get 50% of VIP tickets by using the promo code podcast at checkout. We'll see you there. But for now we'll jump right back into today's episode.
Brandon Hall 10:14
got it got it. So the definition of individual actually applies, it sounds like to really the entire code. And it's found in 98981. It's not an SBU. So basically, it is a real person. And that is what these regulation sections are using to define individual. And we're talking about the material participation rules,
Thomas Castelli 10:33
right. And if you keep reading the task code, and you keep reading over and over again, even though there are specific silos of the tax code, they usually when there are siloed out, they'll specifically define what a word means if they're going to define it something differently. They don't have that in this section, where they're saying that an individual means a person. So if you read the tax code, as you keep reading after this, you'll eventually start seeing that whenever they use the term individual, it's generally referring to a human being it's it's clear, and then when they say a person, that's when they're referring to that group that could be an estate partnership or trust. So you know, that is the evidence that I have to support this.
Brandon Hall 11:14
Makes sense. Makes sense. Wow. Very cool. So what are the takeaways then, like, what does the short term rental owner do with this information?
Thomas Castelli 11:20
I mean, so as a short term rental owner, I mean, really, the biggest takeaway is that when you're working with contractors, when you're working with when you're working with cleaners, that you don't have to worry about, you know, hiring five different companies to come clean your your short term rental, you can hire a large cleaning company, and they can just cycle out their cleaners to make sure that no one other individual spends more time than you. And the same thing when you're doing repairs, and maintenance and things like that. If you're doing you know, minor repairs or maintenance, you'll probably be fine. If you're doing larger capital projects, you may want to look into how you can leverage a team to get that job done, and make sure that you're not leaning too heavily upon one individual to get this done. So that is good news for people overall, it specifically really comes down to the cleaners I think is the biggest the biggest component of it for most people. Yeah,
Brandon Hall 12:10
very interesting. And as a short term rental owner, myself, I will just put this out there for everybody. Don't let the tax tail wag the dog. So while this is very cool, if cycling out individuals hurts your return on investment, and it will, because you will lose efficiencies and you will lose effectiveness. When you cycle out individuals, you just have to do that analysis is that worth the potential tax saving sometimes it might be sometimes it might not be. So don't just dive into this and start cycling you know, cleaners out repairment out contractors out, you know really look at your facts and circumstances first, then make sure that the return on investment is going to be protected related to your short term rental. If I start cycling cleaners out and my five star cleaner, she's already worked enough and it's now threatening my material participation. So I'm going to recycle in another brand new cleaner that's never done it from you before and all of a sudden I start getting one star reviews. That's going to hurt my return on investment. So be smart. Don't just do it for tax purposes. You know, make sure that you are protecting your yield. That's why you're getting into this to build wealth to create cash flow. The tax piece of it is just the cherry on top.
Thomas Castelli 13:24
Absolutely. Absolutely. You always got to keep the investment economics in mind. I said it's big news for short term real estate investors. But that's all for today's episode. We'll catch you next week.
Brandon Hall 13:33
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