Table Of Contents
In this episode, Brandon and Thomas discuss how California, the state with the highest tax rate in the United States, views the real estate professional status and the short-term rental loophole.
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.
Thomas Castelli 0:00
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Brandon Hall 0:05
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Brandon Hall 0:15
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Thomas Castelli 0:30
Hey, everyone, thanks for tuning into this episode of The Real Estate CPA Podcast. Today, your host Brandon Hall and Thomas Castelli are going to discuss how California the state of California views the real estate professional status and the short term rental loophole. So a lot of investors out there in California paying high amounts of taxes, as California has the highest state tax rate in the United States. And these are ultimately strategies they're going to be trying to use and we're going to answer the question today, will they help you reduce your California state tax?
Brandon Hall 1:00
Yeah, we get this question all the time about California. And the reason that this question comes up is because California, one does not conform to bonus depreciation. So you always have to add back bonus depreciation that you take at the federal level. But two, they don't conform to real estate professional status. So in the California instructions, if you look at the FTB, or you look at any of their forms that talk about the passive activity rules, they will say things like, we don't conform to real estate, professional status. And all rentals are passive. So that's where this whole conversation comes from. But if you've been listening to our other episodes, you know that one of our big things is you have to understand the definitions. What do these words mean? Right? The big question that we ask is, well, California says all rental activities are passive. But what is the definition of a rental activity? How does California view that and you can't get that from the instructions, you have to dig a little bit deeper. And that's what we're going to talk about today.
Thomas Castelli 1:57
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Brandon Hall 4:03
Right, right. And so then the question becomes, well, what is the rental activity? So just because they don't conform to real estate professional status? Does that impact my short term rental activity?
Thomas Castelli 4:15
Right, California says all rental activities are passive. And now the question becomes, well, what is a rental activity? So under the federal tax code under Reg, section 1.4691 T three is where you'll find a definition of rental activities. And then under that section, the exceptions to that definition. under that section under Section Three, two, A, you'll find the exception to the definition of rental activity, which is became known as the short term rental loophole, and that is the average period of customer use such property is seven days or less. So the question we have to answer is does California recognize that exception to the rule?
Brandon Hall 4:58
And we've been asking this question For a while, so finally I took it upon myself to dive into some research. And what I found was kind of interesting, found a state level case where a taxpayer was challenging the state of California, because the state of California basically came in and said, Hey, your rental activity is passive. And the taxpayer had taken all these losses. And I believe that the case is Wheeler versus the state of California that I might not be saying that exactly right. But if you look up Wheeler, w h e l e r, verse, the California State Board of Equalization, you should be able to find this. But here's the high level context of the case. So the taxpayers took, they had a rental activity, they were renting a plane. So they had a plane that they own, they were just chartering the plane, they had a rental company that they leased the plane to. And that rental company, that charter company, had all their customers, and they would then lease them out to their customers for the chartering that would happen, the state of California came in and said, Hey, this rental activity, even though you said that it produced a loss, it is a rental activity. So the losses are passive, and you cannot claim the losses against your regular income. They're all suspended. Because California says all rental activities are passive, there's no such thing as real estate professional status at the state of California level. So this plane rental activity, because it's a rental activity, you cannot claim the losses or you can have losses, but they're just passed, they become suspended. So the taxpayers appealed the determination. And they basically like laid out a whole bunch of reasons as to why this is not true. They ended up losing on the appeal. But one of the interesting things in this entire case was that the taxpayers said, hey, the customers did not use the plane for more than a seven day period on average, right? So because of that, we meet the exception in reg section one 469 dash one T three, that says that if the period of customer use is seven days or less, we don't have a rental activity. So the taxpayer tried to say, we don't have a rental activity. And therefore we should be able to claim the losses, because our average period of customer use was seven days or less. Now, California came back in this ruling, and they analyze that. And they didn't say that, yeah, you're right. Or they didn't say if you would have done it this way. You'd be right, but they didn't flat out say that section does not apply. What they did say is Well, the way that it applies to you is that you have a 12 month lease with the charter company. And the charter company has the leases with its own customers. And those leases are seven days or less. But you Mr. taxpayer, your activity is not seven days unless you have a 12 month lease. So you do not meet the exception, under reg section one 469 dash one T three. So what that tells me is that California would follow that reg section, like if you have a short term rental, if they would have chartered it by themselves without the charter company, they probably could have used that exception. And they probably would have been successful in arguing that they don't have a rental activity at the California State level because of this exception to the rule. So it's just kind of an interesting case to look at it. Again, there's, I guess, some risk here in the sense that that wasn't the key issue. It was just one of the appeal arguments that the Wheelers put out. And it was just very briefly discussed. But the fact that it was discussed in the fact that, you know, the state of California didn't come in and say this does not apply to the state of California taxpayers, we just thought was an interesting way for California to analyze that. So we also feel confident that that a short term rental would still be a short term rental or would still qualify for that exception at the state of California level as well.
Thomas Castelli 9:04
Absolutely. And another thing too, is that that's interesting to note is not only do we have this tax court case, but California explicitly calls out in their tax code and within their instructions that they do not conform to Section 469 C seven, which is the real estate professional status. But they do not specifically call out at least anywhere that we're aware that they do not conform to this other section, right. So ones left to believe that they do conform. So we have these kind of two pieces of implicit information or evidence, if you will, to kind of conclude that California's law that should still be non passive, the California state level. And now having said that, I do want to issue a brief kind of word of caution to anybody out there who might be considering taking these losses as passing the California state level. It first of all, we don't have anything explicit, right. We don't have anything saying from California. Yes, this is we do conform to the section or any tax court case. is where someone successfully use this section to win a tax court case in the state of California. And we know that California, the FTB, some people have told us, you know that the California FTB is known to be more aggressive than the IRS as a taxing authority. And if you were to take this on your return, there's a chance there's a chance you might get audited. And then you're going to be probably fighting an uphill battle trying to defend your position. So if you're going to take this position, you definitely want to have a conversation with your tax preparer to make sure that they're comfortable with this and their understanding of everything involved. And if you want all the citations and everything that Brenda and I had just mentioned, on this podcast, we do have an article on tax smart investors.com, where we do lay out the caste court case and the citations that we're discussing here, so that you and your CPA can have a discussion on whether or not this is something you guys want to move forward with. So one more thing, before we wrap up today, we did want to just Well, I wanted to definitely just make sure that to clear out, we did get an email from another CPA within the industry. As a follow up to our episode we did two weeks ago short term rental episode number five, on the term individual. So first, if you haven't listened to episode, go back to short term rental five listen to this is gonna make a lot more sense. But to give a brief overview of this context, there's a lot of people out there in the short term rental industry, excuse me, a lot of short term rental owners, the better way to say it, that are trying to qualify for the third material participation tests. And that's that they spend more than 100 hours on the activity and no one other individual spends more time than them. And by meeting this test, a loss will be non passive, which is why this test is so sought after it's one of the easier ones to obtain. And there's been a lot of confusion in the industry, of what the term individual means. Does it mean a one person human being? Or does it mean a company such as like a partnership or a corporation, or what have you, and what we basically figured out, and what we discussed in Episode STR episode number five is that the word individual means one human being, meaning that you can have multiple individuals working on something and you're not if they all work for the same company, it's not their combined time that you have to beat, but it's their individual time that you have to spend more than that. Right. And then we had the professional reached out to us. And he pointed out three different tax court cases and will include which
Brandon Hall 12:24
by the way, we're very appreciative of so we know that there are CPAs and tax advisers that listen to our podcasts, if you ever have any questions, feel free to hit us up at contact at the real estate cpa.com. Obviously, we want to be held accountable to what we're talking about. And we also want to make sure that what we're saying is clear so that you understand what we're saying. So feel free to reach out. And thank you very much to the individual that did,
Thomas Castelli 12:46
absolutely I only email response back and I will you will hear back from me. But it basically in these tax court cases, it said in all three of them, there's a common theme. And the theme was that the taxpayer had signed a property management agreement with a property management company to handle the day to day tasks, the activity, things such as advertising, coordinating repairs, and maintenance, pretty much everything you'd expect a property manager to do. And we know and we've been consistent on this with both the real estate professional staffs and the short term rental loophole that it's in the IRS ATG, as well as at least three task court cases that we have, where when you sign an agreement with the property management company to take over these responsibilities, you are no longer in the day to day management, and the IRS and the task courts are both going to agree that you're not materially participating. So to be clear, what I'm not saying is, if you have a property manager agreement with a property management company, you're not measuring the time that each of those individuals spent, it's clear, you have a property manager agreement, you're contractually delegating these tests to somebody else, and you're taking yourself out of the day to day, what I'm saying is if you're self managing, if you have a short term rental property, perhaps in some instances with a real estate professional status, where you're self managing your property, and you hire other individuals, namely contractors to help you that you're looking at the time each individual spends, and not the time the aggregate company and the best example and probably the most relevant example for the majority of short term rentals out there trying to qualify using this third material participation test is going to be with cleaners. And what I'm saying is, when you have a cleaning company, you might sign an agreement with them to handle your cleaning, but that's just one part of the overall operations. And if you hire that cleaning company and they have five cleaners come and clean your short term rentals throughout the year. You're looking at em Are you spending more than 100 hours a day? And are is each individual cleaner spending less time than you that's what you do not the aggregate company you're not saying? So basically, let's paint this picture. If each cleaners spent 50 hours right, and you spent 100. They spent less than you if you go by based off individual but if you add five cleaners at 50 hours, that comes out to be what is That's 50 times five, like my rudimentary math is killing me, right? 250 50 Yeah, you're not, you're not aggregating, you're not aggregating those hours together, you're doing it per individual. And that's if you do not have a property management agreement. Again, if you are signing a property manager agreement, where the property management's can be taken over the day to day management, you will lose under audit, and you will lose in tax court. So this is when you are self managing a property to be very clear. And that's just what I wanted to clarify today. And want to appreciate everybody who has listened to the short term rental series and go ahead and listen to episode five if you have not already.
Brandon Hall 15:38
But like, what if you do hire a property management company? And what if you are somehow able to outwork them? Like, do you still look at it on the individual by individual basis?
Thomas Castelli 15:48
I mean, I think he would look at it on an individual by individual basis, however, I think you have a pretty hefty presumption to overcome. And I want to point out into these two tax court cases, at least two of them, of the three that were presented, the records that the either the taxpayer failed to produce any records to support their claim of material participation, or the records were not relied upon or deemed to be unreliable, and then ultimately thrown out. So it might be possible to win a tax court case like that, or to win against the IRS, but you're overcoming a huge presumption. And it's going to be on you to produce the evidence to overcome that presumption. And that could be difficult to do, when you do when you have a property management company trying to get the time that each individual spends in that in that property management company down so that you can present that evidence to the task quarter in front of the IRS to be able to put your case forward.
Brandon Hall 16:41
So they weren't arguing whether or not they were spending more time than the property management company, or any one of the individuals like add issue in these cases was the fact that they had a property management company, meaning that they couldn't materially participate and that their records were bad.
Thomas Castelli 16:56
Right, right, in at least two to three tax court cases. That was the issue was two things at play. They had the property manager agreement that effectively said they were delegating these responsibilities. And then B, they didn't have the proof to prove that the taxpayers material participation was greater than theirs, they just didn't have the proof. The records were either made after the fact and thrown out as evidence, meaning it's done, you were not counting it. So you don't have any evidence proving that you have material dissipated, or the records were, I think I forgot the other the other exact one, the records, just they Oh, the other one, they didn't have any records at all, the other person just didn't have any records to prove they just didn't have anything. So so
Brandon Hall 17:35
your stance is that, you know, those are three good cases. But at issue was not the definition of an individual at issue was the fact that a property management company was doing all the material participation in the taxpayer wasn't really doing anything. And the taxpayer didn't have any records to substantiate. Or if they had records that were bad records, to substantiate their material participation, had they materially participated, there may have been that that argument about what is an individual but we didn't get like, they didn't even get to that point.
Thomas Castelli 18:09
Yeah, in all three of these cases, it was not about the individual is not about the definition of an individual. It was just dad property management agreements, and they had poor records that showed they spent more time in the property management company, but we do know is that in the RS ATG is that they're going to by default, if you're a property management company, assume that you did in material versus paid. So you're already putting yourself at a hurdle right there, you have to have really clear documentation of not only time you spent, but you're also if you're going to use the 100 hour test, you're going to have to have documentation is some form of substantiation of how much time the individuals within the property management company spent to use this as an a viable argument. And we just seen from the tax court cases that presented then the majority of times when this argument is presented, they're going to assume the property management is spending more time and then your records are gonna have to be bonafide. And that's the bottom line. So it's a general rule. If you're using a property management company, you're probably going to be considered to be not materially participating. But if you're self managing, and you're delegating these certain tasks, maybe the repair maintenance item or capital improvement, renovations, in other words, or you know, the cleaning, it's by individual, not by company.
Brandon Hall 19:23
Good stuff, man. You're smart guy. Glad to have you here.
Thomas Castelli 19:26
Thank you. Alright, everybody saw me That's it for today's episode, and just wanted to remind everybody about 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. Done 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 WWE dot tax and legal summit.com to grab your free tickets today. Again, it's WW dot tax and legal summit.com to grab your free tickets today. Well the tax and legal Summit 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.
Brandon Hall 20:27
Thanks for listening to today's show. If you enjoyed the show, please find us on iTunes and leave us a review. You can also email us at contact at the real estate CPA comm with any feedback or topic suggestions, we are always taking on new clients and with the new tax laws in play. You really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs. To become a client navigate to our client page at the real estate CPA calm and fill out a webform with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.
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