Posted by Gigi Boudreaux, CPA, MBA
Thinking of becoming a real estate pro? You’ve heard the term and about the potential tax benefits to being classified as such. You’re thinking that you want in on this sweet, sweet tax exception action. If you’re seriously considering becoming a real estate professional, you need to be certain you qualify. The rules are complex and often misunderstood, both by taxpayers and by the IRS. So let’s back up and broadly review the rules and then address the potential pitfalls.
Losses from real estate activities are generally considered passive. Individuals who participate in these activities may be limited on the losses they may claim on their personal tax returns. Losses are suspended unless there is passive income with which to offset it. In 1993, Congress amended the passive activity loss statute to provide an important exception to this rule. This has become to be known as the exception for real estate professionals.
To qualify as a real estate professional, you must meet the following criteria. Once an individual meets these criteria, they will be able to deduct their real estate losses against other nonpassive income, such as wages and portfolio investment income.
First, the individual should identify their real property trades or businesses as defined by 469(a)(7)(C), which include but are not limited to rental, real property development, construction, management, leasing, or brokerage. Next, the individual needs to determine if they materially participate in each of these activities using one of the seven tests under Reg Sec 1.469-5T. The individual then adds up all of the hours from these real estate activities in which they participate. Here comes the important part. Using the calculated hours, the individual must determine that they spent at least 50% of their time performing personal services in real property trades or businesses and they materially participate in those real property trades or business for more than 750 hours. If so, then they will not be subject to the general rule that all rental activities are treated as passive.
What does this mean? If you have rental losses you may use those losses against your other income as opposed to having them being suspended. This can significantly reduce your personal tax liability including both income tax as well as the Obamacare net investment income tax.
Sounds like a good deal, right? It’s true that many individuals have agreed and applied these rules to their real estate activities and saved significant tax dollars. Recently, the IRS discovered the increased use of the real estate professional exception and has increased their audit efforts in this area.
Here’s the crucial part. The real estate professional must be able to substantiate their participation. Individuals who want to qualify as real estate professionals should document their hours through the use of a daily calendar prepared contemporaneously as the services are performed. Corroborating evidence such as credit card receipts, invoices, E-ZPass records, and phone records should be maintained as well. This is especially important for individuals whose day-job is unrelated to a real property trade or business. For example, an individual who spends 2,000 hours each year as a bank manager and has two rental properties. It’s going to be hard to prove that they spend more than 50% of their time and 750 hours on their rental properties.
The real estate professional exception has been and continues to be a heavily litigated issue. In many cases, the courts have sided with the IRS. Individuals who don’t keep contemporaneous records can prepare them after the fact, but they must be detailed and specific, and must be supported by corroborating evidence. Can you imagine trying to accurately recreate your calendar two or three years after the year being audited for? This is seen as “post-event ballpark guesstimates,” as discussed in Fowler v. CIR (where the taxpayer was determined not to qualify as a real estate professional).
The moral of the story here is: be prepared. The IRS may very well challenge your use of rental losses in order to offset nonpassive income. If you still want to take advantage of the real estate professional exception and hope to withstand such challenge, take the time to carefully track your hours spent on rental activities on a daily basis. (Accountants have been doing this for years. Call us for guidance on keeping contemporaneous records if you’re considering becoming a real estate professional.)