Larry W. Kline & Christine Kline v. Commissioner, T.C. Memo. 2015-144

Mr. and Mrs. Kline owned two yachts in the British Virgin Islands. They rented the yachts their clients used to sail the Caribbean. Since they lived in Arizona, they used a yacht chartering company to handle the day-to-day rentals. A few times a year Mr. and Mrs. Kline hosted clients on trips, with Mr. Kline serving as the captain.

Due to depreciation on the boats, Mr. and Mrs. Kline lost money during a couple of years. The I.R.S. objected to the losses and challenged Mr. and Mrs. Kline in court. The I.R.S. alleged Mr. and Mrs. Kline didn’t materially participate in their yacht charter business. If the I.R.S. successfully proved a lack of material participation, Mr. and Mrs. Kline would lose their ability to offset their losses against their ordinary income. Adding insult to injury, the I.R.S. also asserted a 20% penalty for negligence against Mr. and Mrs. Kline.

Material participation generally prohibits using losses from passive activities to reduce income from non-passive activities. Material participation occurs when a taxpayer “materially participates” in an activity by working on a regular, continuous and substantial basis. (I.R.C. 469(h)(1).) Failure to materially participate results in passive, rather than active, losses. The I.R.S. provides seven tests for material participation. (Treas. Reg. 1.469-5T(a).)

The three most commonly used of the seven tests are:

  1. Taxpayer works at least 500 hours on the activity during the year;
  2. Taxpayer performs substantially all work in the activity; and
  3. Taxpayer works more than 100 hours on the activity and no one person works more than the taxpayer.

Unless an exception applies, passive activities include any rental activity. One exception is rental real estate interests when the taxpayer is a real estate professional. (Treas. Reg. 1.469-9(e)(1).) Mr. and Mrs. Kline met an exception to the general rule because the average period of customer use of the yachts was seven days or less.