What About New York State’s Federal Tax Audits?

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A noteworthy determination was issued earlier this month by one of the Division of Tax Appeals’ administrative law judges. Judge Bennett found in Matter of Chery that the Division of Taxation improperly denied the petitioning taxpayer’s status as a real estate professional, as reported on his federal income tax return. Consequently, the taxpayer was entitled to claim Schedule E rental losses from two rental properties – not only on his federal return, but on his New York State return as well.

This case highlights some of the hazards of a trend we’re seeing with increasing frequency: the New York State Tax Department conducting audits focused on taxpayers’ federal income tax returns. This case and others beg the question: to what extent, if any, should New York State auditors be auditing federal tax returns?

Mr. Chery claimed a refund on his 2008 New York State resident income tax return. The refund resulted, in part, from rental losses reported on Schedule E of his federal return. These losses, in turn, offset some of the income Mr. Chery received from his fulltime employment. And since a taxpayer’s federal AGI is the starting point for computing New York State income tax, the rental losses claimed on Mr. Chery’s federal return carried over to his New York State return. 

The Division of Taxation selected Mr. Chery’s 2008 return for an audit. It likely became apparent rather quickly that his federal return—more so than his New York return—was the real target of the audit since the audit began with a letter requesting information that were clearly bearing on the accuracy of his federal Schedule E, including “a list of services performed and hours attributable thereto.” The letter did not specifically request, nor did Mr. Chery provide, the same information with respect to his wife’s services and hours – though she too contributed hours to his real estate activities. Mr. Chery did, however, provide a voluminous response with supporting documents, a contemporaneous calendar reflecting the activities undertaken in conjunction with his real estate activities, and the requested explanation of his hours and services performed. The response stated that Mr. Chery spent 2,047 working as a U.S. Postal Inspector and 1,872 hours on his rental properties. 

After receiving Mr. Chery’s response, the Division issued a statement of proposed audit changes proposing to disallow the rental losses on grounds that he failed to demonstrate that the losses were not limited by the federal passive activity loss (PAL) rules.  According to the statement, the PAL rules required that Mr. Chery’s rental losses be treated as losses from passive activities, which could not offset his non-passive income. In other words, according to the Division, Mr. Chery was not a real estate professional and therefore, his rental losses were passive activity. And since his the income he received from his fulltime employment was non-passive activity, the rental losses couldn’t offset the wage income.

According to the statement, qualifying as a real estate professional required Mr. Chery to meet three tests:

  1. More than half of your personal services must be in real property businesses.
  2. You must work more than 750 hours annually in real property businesses.
  3. You must materially participate in EACH separate rental real estate activity unless a written election was filed with the ORIGINAL RETURN to treat all real estate rentals as one single activity.

Mr. Chery then made another comprehensive submission to the Division in response to the statement. However, the Division found that Mr. Chery had not substantiated the total hours he claimed as attributed to his services as a real estate professional, which in any event, was less than half of his total hours of personal services for the year. Thus, the Division issued Mr. Chery a notice of deficiency asserting tax due for the reasons outlined in the statement of proposed audit changes.

Mr. Chery protested the notice of deficiency, arguing he was a qualified real estate professional and was entitled to include certain hours previously disallowed by the Division, including hours for services his wife performed. Following a hearing, Judge Bennett agreed with Mr. Chery’s position and ruled accordingly. Specifically, Judge Bennett found that the hours attributed to his services as a real estate professional included not only the 1,872 hours previously claimed but other hours as well, including his wife’s hours. In total, Judge Bennett found 2,052 hours attributed to Mr. Chery’s services as a real estate professional. And this total was just slightly more than the 2,047 hours he spent working as a U.S. postal inspector, thereby satisfying the “more than 50 percent” requirement. Accordingly, Judge Bennett granted Mr. Chery’s petition and cancelled the notice of deficiency.

Clearly this was a good result for Mr. Chery, but the case raises some collateral concerns. For starters, one of the tests articulated in the statement was:

You must materially participate in EACH separate rental real estate activity unless a written election was filed with the ORIGINAL RETURN to treat all real estate rentals as one single activity.

And according to the Division, Mr. Chery was required to meet that test in order to treat the rental losses as non-passive activity. Yet in CCA 201427016 (issued on July 3, 2014), the IRS Office of Chief Counsel issued guidance clearly stating that the qualification test does not necessarily apply separately to each interest in rental real estate absent an election to treat all of the taxpayer’s interests as a single rental real estate activity. Furthermore, Rev. Proc. 2011-34  clearly allows certain taxpayers to file an election after filing their original tax return, so the Division misstated that portion of the test as well. 

The Division was essentially deciding the outcome of the audit based on its own misunderstanding and/or misapplication of the law. Perhaps this is precisely the danger New York State auditors conducting what are essentially federal tax audits.  

For now, we’ll wait and see whether the Division decides to appeal the Chery case to the Tax Appeals Tribunal. While ALJ determinations are not precedential, the vast majority are sustained by the Tribunal on appeal – and certainly the Tribunal’s decisions are precedential. Regardless, the Division of Taxation typically takes heed of ALJ determinations…well, most of the time, anyway.    

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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