Large Loss Allowed for Materially Participated Taxpayers in Real Estate Enterprises

The Tax Court has held that a taxpayer that stepped in during the 2008 financial crisis to rescue several related family businesses in which he held interests did so as a material participant, not as an investor. On the facts, the passive activity loss rules didn’t apply, and he could carry back a large loss to 2006 and thereby generate a refund of over $5 million.

Background. Taxpayers can’t use passive activity losses to offset nonpassive income. A passive activity is any trade or business in which the taxpayer does not materially participate. Taxpayers have a passive loss if their aggregate losses from their passive activities exceed their aggregate income from passive activities for a yearFor purposes of the passive activity rules, a taxpayer’s activities include those conducted through personal service corporations, closely-held C corporations, S corporations, and partnerships.

Facts. A successful businessman helped fund three businesses for his children, structuring each business with one child as the majority owner holding 60% of the shares, and the other two children each holding 20%. One of these three businesses, Shoma Development Corporation, an S corporation, was owned 60% by the businessman’s daughter, Maria Lamas, and her husband, Masoud Shojaee, and by Jose Lamas and his sister Alejandra, who each owned 20%. Shoma and the other two businesses were all related in some way to the business of real estate and tangentially to each other.

In 2004 Shoma formed Greens at Doral, LLC, a condominium conversion project. Shoma and Greens were closely intertwined. Greens had the same ownership structure as Shoma and consolidated its financial information with Shoma’s. Greens operated out of Shoma’s offices using Shoma’s employees, and the shareholders planned to liquidate Greens after the conversion project was completed. Greens was treated as a partnership for tax purposes.

Jose Lamas owned 20% of Shoma and Greens and served on Shoma’s board of directors. Throughout 2008, a bad year for real estate, he labored to raise capital for Shoma and find additional investors for Shoma’s projects to fill its capital needs. He spent considerable time trying to line up outside investors and purchasers for Shoma’s projects in an attempt to cure Shoma’s capital deficit. Much of this time was spent speaking on the phone with potential backers and meeting with them over a meal. Lamas also was involved in a lawsuit involving, among other things, the recovery of Shoma assets that his brother-in-law, Mr. Shojaee, had misappropriated. The parties settled in 2008.

Lamas had provided financing for a condominium conversion project called Bella Vista, and when its owner declared bankruptcy, Lamas took it over to try and salvage his investment. Lamas assumed a management role after taking over the Bella Vista project. He negotiated with plumbers and electricians who had worked on the project, took over tenant management, and dealt with existing code violations. After Mr. Lamas took over the project, he was responsible for the day-to-day finances, and he arranged for essential project loans.

Lamas incurred substantial losses in 2008 from Shoma and Greens. He claimed these losses as a tentative carryback adjustment to 2006, resulting in a tentative refund of $5,260,964.

IRS audited Lamas’s 2006 and 2008 returns, determined that Lamas’s 2008 NOL from Shoma and Greens was passive instead of nonpassive, and ultimately issued a notice of deficiency of $4,911,669 for 2006. During the audit, Mr. Shojaee originally made statements supportive of Lamas, but after yet another family conflict over a real estate project, which didn’t end well for Shojaee, he wrote IRS that Lamas hadn’t been a material participant in Shoma.

Activities were nonpassive. After weighing all the evidence, the Tax Court held that Lamas was a material participant in Shoma and Greens for 2008. As a result, it OK’d his claimed carryback to 2006. The Court cited the following factors in arriving at its decision.

Single economic activity under the grouping rules. The Tax Court determined that Shoma and Greens met all the five criteria: both were similar businesses engaged in commercial and residential real estate. They shared common control and ownership for the years at issue; they shared geographic locations (Greens operated out of Shoma offices), and they were interdependent (Greens used Shoma’s employees and consolidated its financial reporting with Shoma, and shareholders intended that Greens be dissolved after the project was completed and the capital returned to shareholders).

More than 500 hours of material participation. The Tax Court found that Lamas worked at least 691 hours for Shoma and Greens during 2008 . Credible testimony and phone records supported this conclusion. Mr. Shojaee’s inconsistent statements and personal conflicts with Mr. Lamas called his credibility into question, and the Court gave no weight to Shojaee’s testimony.

Participation wasn’t as an investor. The Tax Court rejected IRS’s contention that Lamas’s work for Shoma didn’t qualify because he was merely working in an investor capacity and wasn’t involved in day-to-day management and operations. The Court found that Mr. Lamas worked in the day-to-day management and operations of Shoma because he was working to meet its need for capital for its projects, an essential part of Shoma’s business during 2008. Mr. Lamas’ promotion went to the core goal for Shoma at the time, which was to find project investors. Accordingly, all of Mr. Lamas’ work for Shoma, including investor activity, qualified as participation.

Exception for work not customarily done by owners didn’t apply. On the facts, the Tax Court concluded that Lamas participated in work customarily done by owners, and he did not do this work with a purpose of avoidingloss limitations.

Significant participation activity test met. Even if Lamas worked fewer than 691 hours for Shoma and Greens during 2008, he would still qualify as materially participating, by having significant participation activities that exceed 500 hours in the aggregate for 2008. The Tax Court found that Lamas worked at least 294 hours during 2008 for Bella Vista. Thus, even if Lamas’s work for Shoma and Green had been less than 500 hours, Shoma and Greens would then qualify as a significant participation activity that could be aggregated with Bella Vista. Under that scenario, Mr. Lamas’ significant participation activities, Bella Vista, Shoma and Greens, exceeded 500 hours.