Real Estate Professional Status Under IRS Attack
Real Estate Professional Status Under IRS Attack
© 2008 Diane Kennedy, CPA/Tax Strategist
The Real Estate Professional status has been a great loophole and, actually still is, if you follow the rules. But the IRS has found a few people who were taking advantage of the rules and so they’re on the hunt for anyone using this designation.
Here’s what the rules were three years ago: If you made under $100,000 adjusted gross income, you can deduct $25,000 in real estate losses. If you make over $150,000, you can’t deduct anything. In between, the deductible amount phases out. The exception is if you’re a real estate professional. Thousands of people then took the steps to legally qualify as a real estate professional. And now, it looks like the IRS is challenging that definition.
A primary target is the real estate agent herself. One of our USTaxAid/TaxLoopholes community members reports that he’s currently under audit for taking the real estate professional deduction on his joint return. His wife is a real estate agent, does not have any other job and reports the commissions she receives through her legitimate business. Because she claimed the real estate professional status, they then took 100% of their real estate losses against their other income.
The IRS auditor has taken the position during the audit that because one of the requirements is that she is “brokering” deals, she isn’t qualified because she’s not a licensed broker.
Apparently there have been a few cases of IRS auditors in California taking this position. I know of two cases that are planning to fight it in Tax Court. If they win, we’ll have a precedent that might stop the IRS tactics. But, if they lose, everyone who has claimed the Real Estate Professional loophole based on being a real estate agent needs to be prepared for an audit.
The timing for this aggressive IRS audit crackdown couldn’t be worse. At a time of dropping home values, tightened credit and a general malaise in the housing market, an aggressive IRS audit specifically targetting the people who are suffering the most in this economic time can’t be good for anyone. But the IRS has their job too and that’s to raise tax revenue.
One more horror story from my USTaxAid/TaxLoopholes forum:
“We just got hammered by the new IRS restrictions for being a Real Estate Professional. The IRS has just finished an audit for my wife and me for the 2004,2005,2006 tax years. We have several rental properties in Missouri. We have been using a CPA as a tax advisor over the last several years. I have felt that he is well qualified with real estate business in order to to help us understand and document the activities that would qualify my wife as a real estate professional. I have a full time job, and we had declared my wife to be a real estate professional. This was her only occupation. Since our joint income has been more than $150,000, we believed that having her qualify as a Real Estate Professional would enable us to take depreciation and other passive losses every year as they have occurred on our rental properties. However, as a result of the audit, the IRS has decided to disqualify her as a Real Estate Professional.
According to the IRS audit team (yes, more than one auditor was involved), over the last three years, the IRS has been researching the topic of Real Estate Professional for quite a while and there is now a very detailed internal IRS publication used by auditors to determine Real Estate Professional status and has now very detailed information about what activities qualify as valid activities for a Real Estate Professional. The IRS audit team used these new standards to review every hour of activity that my wife documented for each year as a Real Estate Professional. It is my perspective that the IRS is really getting on the warpath about Real Estate Professional status. We were very diligent in keeping track of my wife’s activities, recording on a daily calendar every activity that she did in support of our real estate LLC. The IRS went through this diary very carefully, and, according to their new Real Estate Professional guidelines, disallowed many of her hours. They disallowed enough hours so that she no longer had 750 hours of qualified activities each year. As a result, many of our passive losses in each tax year were disallowed.
Some of the activities that were disallowed were:
1. Researching the market for new properties (!!!)
2. Overseeing repairs done by a contracting company.
3. For those properties where we used a property management company, any coordination with the property management company was not an allowable activity.
The activities that were now categorized as unqualified activities have really surprised both our CPA and us, especially that you could not include hours that were spent in search of new real estate investments.
The final ruling of the audit expressly said that in order to qualify for Real Estate Professional status, that someone needed to put in 750 hours in directly and actively managing and maintaining their own properties and tenants, and that it did not include hours spent in working through a property management company. In my opinion, these new standards for qualified activities of a Real Estate Professional means that a Real Estate Professional would have to own quite a few properties. Now, we will be able to claim most of our passive losses for a property in the tax year that we sell that property. However, In the meantime, we had to pay tens of thousands of dollars in back taxes, interest, and penalties for the tax years of 2004-2006.”
Tags: Diane Kennedy • irs • loopholes • real estate
91 Responses to “Real Estate Professional Status Under IRS Attack”
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Im being audited as well. I owen an 8 unit building, and three seperate 2 unit buildings. On of which I live in. So I manage and rehab my other 13 apts. I do basically everything…snow removal, land scaping complete rehabs, screenings of tenants evictions etc…etc…. I have to say my recorsd keeping is not that great ,, but I do have all reciepts and the proof is in the before and after pictures. I am about to present thease pictures to the agent soon but the feeling Im getting from him is this is not going to be enough. I mean how many properties do you need to qualify for this deduction? I have another job (36 hrs a week) but work it in three days (12 hour days). The rest of my free time is doing something on these properties but I dont think the agent is buying it.
I am in business as a Residential Real Estate Appraiser. I want to purchase a rental property that I will manage and maintain. My business is a Sub S Corporation. I own it 50/50 with my hu*****and.
I anticipate that my time will be spent as follows: (1) APPRISAL Business 1200 hours (2) Rental activities — management and maintenance 150 hours (3) Part time consulting (engineering) 700 hours.
My questions are:
Can I hold the property in the Sub S Real Estate Appraising (and investing) business?
Am I considered a Real Estate Professional?
Will I be able to take passive losses from the Sub S Corpation on my personal return?
Ken, I’m sorry that I missed your comment until now. I have a feeling the audit is over. Hope it worked out!
In general, you need to prove that you have done more hours in real estate activities then your other job and at least 750 hours per year. In your case, you’re going to need to prove that you had 37+ hours per week in real estate activities. You should have a journal or calendar to document what you would were doing.
You also need to prove you had 500 hours per property, unless you have elected to aggregate on your tax return.
Jean, under the more strict definitions that IRS auditors are using, you will not qualify as a real estate professional. Appraising is not specified as a real estate activity. (I know, I know – it’s all about real estate or else you wouldn’t be doing it!0 The Engineering also does not qualify.
If you have real estate appraisal company losses, those can be taken against other income. Most likely the real estate losses can not be unless your income is under $100K. If it is, then you can take $25,000 of loss.
Mo, probably not. You would need to have more hours in your real estate activity then any other trade or business.
Judy, you might want to do a search on this site and on my companion site http://www.USTaxAid.com for the term “real estate professional.” You’ll find a number of articles and lots and lots of comments about what that means and how to qualify.
Income averaging sadly went away a number of years ago.
My suggestion is to have a tax pro prepare your return. But make sure the tax preparer is experienced in specifically what you do – in this case, real estate investing.
Best of luck!
Hi Diane,
In 2009, I clearly met all the requirements to be classified as a real estate professional. However I am not sure if one of my 2010 jobs would allow me to classify. In 2010, I was a consultant for a real estate company. I did not personally lease, manage, construct, etc property. I managed a database of real estate properties that track certain attributes of those properties. Can you please let me know if you think I would qualify as a real estate professional? Would the work I did be considered working in a real property trade or business? Thanks
Hi Diane,
I own a 16-unit apartment complex and 6 single family homes and 1 duplex. I alone acquire, hire repair people, lease out, and manage all these. I have extremely detailed docs and log book. I alone write all checks and do all the day to day activities for this rental business. I added approximately 1100 hours for 2010, which I am being audited. I have no other W2 income or children. I am wondering how worried I should be about this audit. Any comments?
Clydette, It depends on what the auditor is looking for. If it is simply the real estate professional issue, it sounds like you clearly qualify and have the back-up to prove it. But they could be looking at expenses, basis or any of a hundred other items. The letter they send for the audit should give you a clue as to what exactly they want to see.
Hi Diane,
I(single) currently rent out 2 out of the 3 rooms at my home and looking to get Real Estate Professional Status. So i share the common areas with my tenants. I feel like I satisfy the 750 hours, and being materially active in the property since i live/sleep there too. I have a 40 hour a week job, but since I live in the same space as the other tenants, will that make me less likely to get audited? How likely will I be audited? I feel like I’m constantly looking after place, inspecting, cleaning, repairing and providing useful supplies for the rental. I can see it would be hard to pull off real estate professional status if you have you own home, have seperate rental units, and have a 40 hour a week non real estate job. What are you thoughts on that?
Thanks,
Randy
Hi Diane,
I was curious how do the rich, who normally have a full time job, use real estate as a tax loophole. Since they make too much to use the 25K passive rule, and can’t get the Real Estate Professional Exemption.
Thanks,
Randy
Randy,
A couple of distinctions here: You would need to spend more hours in real estate activities then your job. So you don’t have to meet the 750 hour requirement, you have to meet >40 hours per week requirement.
The income you make from the two rooms will be offset by a pro-rata share of mortgage interest, property tax, HOA dues, utilities and the like.
You have some extra cash flow that won’t be taxable, but I think it’s unlikely you’ll qualify as a real estate professional.
- Diane
Hi Diane,
I have a full time job & have documentation that I spend 1,450 at “work”. I also have a six family building, a two family building and several single family homes. I am Married Filling Seperate status & I claim Real Estate Professional. I maintain daily logs of all my time & had notrized Affadavits form 8 of my tenants atesting to all the work I do including collecting the rent, removing the garbage, preparing leases, painting the apartments & common areas, cleaning the common areas & front & back yards, snow removal, etc. The auditor only accepted the time for collecting rent & repairs/maintenance and nothing else. I don’t understand? According to NYC Housing Code I have to maintain the common areas clean, provide garbage removal services, etc. Why does that time not count as an operating activity for Real Estate Professionals to the IRS. What can I do?
Joanne,
Did you have a representative with you during the audit? If not, get one to assess whether it makes sense to appeal. Depending on time limits, your choices (most likely) are to (1) accept it (2) ask for a supervisory review (my recommendation, if possible) or (3) formally appeal. If you go with the supervisory review, make sure you have a solid case with code and case cites. That’s where you’ll need a professional to help you. I’m sorry it happened to you, from what you say, you should have kept the deductions. My guess is that it was interpreted differently, you got an auditor who didn’t understand or someone was having a bad day.
Diane,
Do you have to log every single hour of the year for Real Estate Professional or will the IRS accept, say 1 month that clearly shows significantly more 750 pa or 1 month each quarter?
Many thanks
Remember you have to get 750 hours and more then any other trade or business. I don’t think it would be physically possible to get that many hours in one month, but if you can and they are all clearly justified, then yes, that’s all you need.
Personally I would recommend that you keep a full calendar and if one month is only 10 hours, so be it. But it shows intent and that you are serious about what you’re doing.
I am a full time teacher in michigan and Im getting my real estate liscense. Im planning on working full time as an agent as well and I have two rental properties..Does that qualify me as a real estate professionalI am a full time teacher and I am planning on getting my real estate
Diane,
Thank you for your answer. I guess I wasn’t clear in my question. I’m not suggesting that I would document 750 hours in a single month. What I’m asking is would the IRS take a month, or a month for each quarter, than shows significantly more than 750/12 (62.5) hours in that sample month?
I guess there are other advantages to keeping an accurate log of your hours too. I can show that I do significantly more that my partner!
Diane,
1. If you have an expired real estate license, do you still qualify for R.E Professional Status?
2. Does it apply for owning and managing your own vacation rental?
3. And if so, which of the following can be included in the 750 hours?
a. Time communicating with potential and/or paying guests ,
b. Buying and stocking supplies for guests,
c. Managing your cleaning crew whether you are able to be there or not,
d. Cleaning the home yourself,
e. Setting up your advertising campaign.
4. What other deductibles are allowed for vacation rentals?
5. What are the red flags or items that I should avoid declaring, etc?
Thanks,
Jeannie
I wanted to know if we document hours looking for property or going to a property because of no money from the tenant that lives 800 miles away is a valid excuse for rental time.. I also work after hours buying and picking up supplies from Stores and we install hotwaterherters and ect.. We hire some of the work but do most of it ourself..
My hu*****and is a teacher so he is off all summer and 2 Weeks Christmas,2 weeks Spring Break and time for holidays.. Could he if he spends with me over 1200 hours per year managing 12 properties…
Hi Diane/All
Is there a comprehensive list somewhere of what type of hours can typically be accepted in a log? Can time spent taking classes, exams, acquiring license, etc be counted?
Thanks
Bruce
Hello. I have a full time job and my wife does not work outside of the home. We file jointly. We only have my single employer provided W2. We own 2 rental properties that my wife manages. This includes finding tenants, collecting rent, and dealing hiring out maintenance when needed. We do not use a management company.
Two questions:
1)
Assuming my wife keeps detailed records that account for greater than 750 hours, will she qualify as a real estate professional?
2)
This is our 4th year operating managing these properties and have not previously made this designation, can we capture the past losses in our next return?
Thanks Dez.
Dez, if your wife’s detailed records show qualified real estate activities that are 750 hours or more and you have material participation (500 hours or more per property), you will likely qualify for a real estate professional.
You could go back and amend your returns to make the designation. Remember that this extends the statute of limitations for the IRS and gives them another look at your returns.
Hi Diane,
Back to my comment last year. Some say that since you are living and sharing space with a tenant that you could be techincally be spending time thinking/cleaning/repairing/maintaining/working on the rental the times you are home and on the weekends, which would put you over 750 hours and also over the 40 hours a week you work on your day job. Seems like this is up to interpretation? I can see both ways. Your thoughts?
Thanks,
Randy
Hey Diane,
My wife and I file jointly. She is stay at home mom and takes care of 1 rental property. We do not use a property manager. According to the IRS rules we are unable to use rental losses as our AGI falls us out of qualification.
Question: Can my wife qualify as a “real estate professional” if she documents hours spent and meets them?
Thanks in advance,
Ray
Thanks Diane,
Just a clarification.
If I want to deduct losses from prior years, do I need to amend returns, or can I simply carry forward those losses which were ineligible in years prior before making the real estate professional designation?
I think this would go in line 1c of Form 8582 (Prior years unallowed losses)
If so, it would mean just waiting to take these losses next year, rather than filing amended returns, which I think would be preferred.
My hu*****and and I are being audited for claiming the Real Estate Professional 100% deduction of rental losses. He is the licensed real estate broker and I am not, but I was the one doing all the work managing and handling our rental properties (2 duplexes in state, and one home out of state). I easily worked 750 hours per year on this; it was all I did, no other job. We deducted 100% of our losses against my hu*****and’s income. As I understand it, our accountant failed to make an ‘election’ to combine all 3 properties (which would have allowed me to work a total of 750 for all 3 properties). As I understand it, without this election you have to have worked 750 on EACH property. Thus, we may be out of luck? Do you know anything about this supposed required election to combine the properties? Do you know if you can make it retro-actively? Do I understand this “election” correctly? Any help at all is greatly appreciated.
Carol, there is a new Revenue Procedure 2010-13 that allows you to make the election retroactively. Unfortunately, it’s so new that most IRS auditors are not familiar with it. Make sure you have good representation through the audit who is aware of the real estate issues like this. BTW, it sounds like your hu*****and is the real estate professional and you met the material participation requirement, which is perfectly okay.
Dez, the unallowed losses from the prior year should continue to roll forward on your return. Unless you didn’t properly report something in the prior years, I would not suggest that you amend the returns.
Diane, my hu*****and and I have received a letter from the IRS stating that they are disallowing our Real State professional election for our 2009 return, as they said that we did not actively participate more than 750 hours for each property (we own 6 properties back then) and added that the following activities do not count towards the 750 hours: Collecting deposits/income, depositing deposits/income, cutting the grass, shoveling the snow, maintaining the premises, answering phones, checking the mail, drive-bys and tax preparation.
My hu*****and is solely dedicated to our real-state business and does not have any other job and he is the one that does everything for those properties, renting them, prospecting for new tenants, all the repairs, collecting the rent, etc. He solely manages all the properties.
Is this right? can they disallow the time he spend doing the repairs and/or collecting the rent? I would truly appreciate any help that you can give us. Thanks!
Hi Diane,
I’ve read some of your books and they are really helpful. Thanks. As you probably know, California does not recognize the Real Estate Professional status. Do you know of some other means to reap the benefits of this status for my state taxes?
This is news to me – we have 6 properties and for the past 2 years used the 750 hrs across all three in a similar situation to above – FT working spouse, at-home spouse doing management as well, filing as Active not passive RE Pros. We first purchased and renovated them sequentially over a year’s time when there was no earned income and this was FT activity; then one spouse went back to work. They are all rented and we continue to self-manage, filing jointly and not as a business. I read 2010-13 and it says “two or more business activities” require an election to group. Is that really meant to signify two or more rental properties/homes, or rather two or more separate business functions or business entities? e.g. both owning rentals and running a FT business flipping homes, or owning rentals and operating as a licensed real estate salesperson, etc.
“• Effect of failure to report: A taxpayer that is engaged in two or more trade or business activities (or rental activities) that fails to report whether the activities have been grouped as a single activity will have each trade or business activity (or rental activity) be treated as a separate activity for purposes of applying the passive activity loss and credit limitation rules of section 469. However, a timely disclosure will be deemed made by the taxpayer who has filed all affected income tax returns consistent with the claimed grouping of activities and makes the required disclosure on the income tax return for the year in which the failure to disclose is first discovered by the taxpayer. If the failure to disclose is first discovered by the IRS, the taxpayer must also have reasonable cause for not making the required disclosures. In addition, the Commissioner may regroup a taxpayer’s activities to prevent tax avoidance pursuant to Reg. section 1.469-4(f). Thus, Rev. Proc. 2010-13 provides alternative relief for untimely filing of the disclosures; relief for untimely disclosures under Reg. section 301.9100 (“9100 relief”) is not available. “
answered my own question by reading here http://www.irs.gov/publications/p925/ar02.html about passive vs active, RE Professional rules, and grouping, with lots of examples.
Hope, it sounds like the IRS agent has the Real Estate Professional (REP) and the material participation rules confused.
The REP requires 750 hours or more and more REP hours then any other business. Material Part requires 500 hours or more per property unless you make an aggregation election. Back in 2009, you could not make a retroactive aggregation election. Starting in 2010, you could. Unless you get them to allow you to make that late election, you may be stuck on this one.
Gina,
Real estate losses in California are tough because you can’t use the REP designation (as you know). Honestly, best bet is to start a business. You get the write-offs in CA at least!
Blake, the grouping guidelines come from Rev Proc 2010-13, which became effective in 2010. Prior to that, we had to make timely aggregation elections on the return. The Rev Proc is a lot more friendly, allowing you to make elections retroactively.
Hi Diane,
Thank you for your response. Just to clarify, when you say the ‘best bet is to start a business’, do you mean incorporate?
Thanks again,
Gina
Hi! We are in the midst of an IRS audit where we completely disagree with our auditor. We met with his supervisor tonight and she told us our only option is to appeal.
I have read, re-read and read again and again multiple websites and articles related to the ‘real estate professional and material participation’ rules. Can you please help me distinguish this issue?
I am a real estate professional. I’m a Qualifying Broker of my own company and have been for 10 years. This is my only source of income. I also jointly own 3 rental properties with my hu*****and – 1 of which is in-state (NM) and the other 2 are out of state (AZ & ME). We are trying to understand and interpret the active vs. passive income/loss IRS code.
Is the 750 test of qualifying as a real estate professional just that? I own & operate a residential real estate brokerage. I represent buyers and sellers buying and selling homes and land. I work 60-70 hrs/week at a minimum. Do these hours need to ‘include’ my own portfolio? We elected in 2007 (when we got married) to treat all of our properties as one activity. Do I need to spend a minimum of 750 hours JUST on my rental properties to qualify as a real estate professional? Or do my 750+ hours on my real estate brokerage and clients qualify me to pass that test?
My understanding is that I can qualify as a real estate professional as being a Qualifying Broker and spending a minimum of 750 hours in the real estate trade. In addition to this, I must pass ONE of SEVEN tests in my personal rental properties to qualify them as active investments to recognize active income/losses.
Am I incorrect here??? Our auditor’s supervisor told us that I must spend 750 hours of my real estate profession ON my own properties AND pass 1 of the 7 material participation tests. Why would I spend 750 hours + additional hours on my own properties to qualify? If my 750 hours were ‘material’ participation why would I then to need qualify for more hours per property or as a grouping of properties? I’m so confused and frustrated – we just want to get this right.
Thank you.
There are two tests for the Real Estate Professional deduction. (1) You have to be a real estate professional. It sounds like there is no question that you meet this requirement. (2) You must have material participation.
Material participation is defined as 500 hours per property per year. If you make an aggregation election, then you need to only meet one 500 hour requirement.
A couple of things to note here: You quoted ‘active’ participation which is different than ‘material.’ If you make less than $100K AGI, then you just have to meet the active participation standard. If you are a real estate professional and income is over $100K (which is why you’re taking that position) then you need 500 hours.
The IRS ATG has a mistake in it, so your auditor may be misreading the requirement. The ATG is the audit handbook that the auditor is likely using. In the beginning narrative it states 500 hours for the material participation requirement. But in the checklist near the end of the ATG it says 750 hours. It should be 500 hours. If you can’t convince the supervisor of that, drop another note here and I’ll give the appropriate cites in tax law.
The IRS had previously, incorrectly, taken the position that a real estate agent didn’t qualify as a real estate professional. They lost in tax court on that argument. LMK if they are making that false claim in your case.
And finally, in the past the IRS did not allow taxpayers to retroactively aggregate properties so that you don’t have to meet the 500 hours per property requirement. They lost that argument just recently. They have to allow you to make that aggregation election.
FINALLY: Talk to your CPA before you make the aggregation election. It can bite you if you later sell at a loss. You need to de-aggregate first.
hi diane, we got auditted 2 months ago. i own 3 rental properties in nyc. irs is claiming that i can’t deduct the 25,000 loss cause i have a full time job. my account just told me we should wait for the judgement. my questions are these
we plan on appealing if they say i need to pay. can we make up logs for the years they are fighting me on?
my wife is a stay at home mom. she goes for the rents, does the garbage, clean hallways, change bulbs etc, if she logs more than 750 hrs per year per property is she considered a real estate pro?
The IRS will want to see that you have more hours in real estate activities than you do in your full time job. Either you or your spouse can qualify, but it sounds like it might be easier for your wife to qualify. In her case, she will need to prove that she spend 750 hours or more in real estate activities.
It’s usually much better to deal with audit issues before they go to appeals. You can solve problems faster and way cheaper at that level. As you move up the chain, your accountant or attorney will need to be more involved and the cost to you goes up.