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.”
February 5th, 2009 at 4:10 pm
How about auditing the CEO/CFO etc…crooks who stole billions of our tax money;; where is the IRS then? How about auditing the Citibank million dollar tax payer airplane? How about auditing the Wells Fargo billionaire welfare bailout?? Where’s the IRS then….go after the little guy. No rights.
Funny how they only go after the little people trying to pay their bills and have some rental?
It is embarrassing to be an American.
February 10th, 2009 at 3:01 pm
Why is it legal to apply “new IRS restrictions” on the real estate professional status in 2008-9 on taxes filed in past years , when the restrictions were not in effect until now, or clearly stated in the tax law. Laws in effect, as well as their interpretation, in 2005 should apply to those taxes filed in 2005. You can’t write the rule today and apply them backwards. It is illegal as well as wrong to expect folks to know and anticipate future interpretations.
February 10th, 2009 at 6:59 pm
The problem is that tax law is comprised of so many pieces. There is the IRS Code that says what to do in very general terms, then the IRS Regs tell us how to do it and Rev Rulings, Procedures, PLRs and court cases round it out.
The IRS, I believe, is trying to force the hand of taxpayers who took this deduction and make them force the issue in court. The IRS is kind of in a “no lose” situation. They have lawyers on staff to fight the issue and if they make a taxpayer loose, they have precedent.
Is it fair? No. I don’t think it is either. Figure as much as $50,000 to fight a lawsuit.
February 22nd, 2009 at 7:54 am
SO, I AM STAY AT HOME MOM, MANAGE TWO RENTAL PROPERTIES WHICH I OWN. I DO NOT HAVE A MANAGEMENT COMPANY OR ANOTHER JOB. THIS YEAR I CAN ACCOUNT FOR ABOUT 750 HOURS ON BOTH PROPERTIES IE PAYING MORTGAGE, TALKING TO TENANTS, VISING THE PROPERTIES, PAINTING, CLEANING ETC…I AM NOT A LICENSED PROFESSIONAL.. WILL I HAVE PROBLEMS IF I CLAIM THE REAL ESTATE PRO STATUS..sam
February 25th, 2009 at 7:33 pm
sam, please come over to http://www.TaxLoopholes.com. I have a number of blog posts over there on the real estate professional status. You may be able to qualify, but this is definitely something you don’t want to make a mistake on. The IRS is really on the attack in this area.
November 22nd, 2009 at 7:53 pm
I’ve been engaged in taxations for lengthier then I care to acknowledge, both on the individual side (all my working life history!!) and from a legal stand since passing the bar and pursuing tax law. I’ve furnished a lot of advice and corrected a lot of wrongs, and I must say that what you’ve put up makes utter sense. Please continue the good work - the more people know the better they’ll be equipped to deal with the tax man, and that’s what it’s all about.
December 2nd, 2009 at 12:56 pm
Diane,
I purchased 10 properties in the Go Zone in 2007. As I understand it, research does not qualify as active participation, but “acquisition” itself qualifies as active participation. After purchase I used a property management company for 6 of the properties. Does the use of property management NEGATE the hours I put in acquiring the property? Also, I run and manage the HOA for these properties - oversee management of the entire development. Does that management qualify as active?
December 4th, 2009 at 7:30 am
The property mgmt company won’t negate any hours. The challenge that you’d get in an IRS audit is whether you managing the property management company is active enough. If you had enough hours from other activities - finding the property, fixing it up, etc..
Tricky on the HOA management. Hours count if you own 5% or more of a company. But if you work at a non-profit, then you can’t own it, so the hours won’t count.
February 24th, 2010 at 11:38 am
We have benefited from the Real Estate Professional exception now for years and so far without any problems.
A common theme I find running through most of these cases is the owners really didn’t manage the property or the hours reported are absurd. Take a Denver physician and his wife who claimed to be full time managing their two ski condos and writing down time spent driving to the mountains on ski weekends.
Another common one is like the gentleman above. If you have a management company interviewing tenants and leasing units and you only own a few how does that occupy most your time? Especially if they were rented for most of the year without too much turn-over? Isn’t there a smell test on what is reasonable regardless of what you “documented” on a piece of paper?
Those cases are easy to understand why they were audited. What about owners with multiple properties they really actively manage? Do you need to own more than 5 or 8 or 10 before it seems reasonable you spent 750 hours on them?
I wish someone would investigate the true guidelines and focus on discussing the ability to use the loophole for those of us who own and manage rental properties.
In my case I have a full-time job with an active income over $150,000. My wife really does manage the rental properties from home without having any other job so we deduct those “passive” losses against my active income.
Does anyone know what objective criteria the internal IRS audit manual uses to trigger an audit? Number of houses, minimum percent of ownership and other specifics would really help everyone forllowing this issue.
Thanks
March 26th, 2010 at 12:57 pm
This is a very interesting blog and i appreciate everyones inputs. I started buying, renovating, and renting out real estate this year and I have quite a few units operational already - many more coming for 2010. I spend the vast majority of my time doing the real estate activities mentioned above, but I take a full salary from my wife’s advertising agency for “consulting” work. Quite frankly, after what i have read, I am afraid to declare myself a real estate professional even though i could easily document the 750 hours. It may be difficult to show that my “consulting” is less than 50% of my time, since we do not track our hours for the advertising agency. The hassle of the audit and possibility for all the back payment, interest and penalties is terrorizing. This is nuts. Why does this country want to beat up on the little guys? Isn’t there enough big guys out there to beat up on?
June 12th, 2010 at 6:22 pm
Does anyone know if real estate training/education related time can count toward a portion of the 750 hours?
June 26th, 2010 at 2:58 pm
Bryan, the training and education is something that the IRS is systematically throwing out when they calculate the hours. I don’t believe that anyone has challenged the IRS on this and won.
July 2nd, 2010 at 8:00 pm
Diane,
I am a CPA,MST who does a great deal of work with real estate investors. (Let’s disregard the hassle I am going through with the first time homebuyers credit.) I have several clients that clearly (at least appear) to qualify for real estate professional status NOW and in this market. Several have prior year passive activity loss carryovers related to real estate as a result of AGI limitations. You have clearly done quite a bit of research in this area. What is your thought on converting prior year carryovers to non passive? It is quite possible that they may have qualified in prior years but did not have a tax preparer that understood the law. Can I do a retro amendment or is there a “timely filed” requirement? Real estate taxation is a specialty area! Most investors do not understand that a “storefront” tax service is NOT going to get them all of their benefits!!!
I’d appreciate any off the cuff input you may have. Thank you!
Lisa Martin
Farmington Hills, MI
July 5th, 2010 at 5:26 pm
Hi Lisa
The Real Estate Professional (REP) status does not have a time requirement. The other part of this, though, the material participation requirement of 500 hours per property applies. If the client instead wanted to aggregate the properties, that election must be filed with the original return.
Hope that helps! Diane
July 8th, 2010 at 7:58 am
Diane:
I have a client who consists of two 50% partners that rent 2 properties. They have each been claiming the Real Estate Professional status for years, but may be under audit soon. About 65% of their rental income is drawn from a self-rental (to another business that they oare involved in). The rest of the income is from a 3rd party renter. There is no turnover in tenants.
Also, even though one of the partners may really qualify as a real estate professional, the other one will not, (based on the fact that he works greater than 50% at the other business that they own)
Question #1: Does the self-rental “not count” in the determinatin of the 750 hours, etc, criteria? Or can we see it as a legitimate tenant?
Question #2: If one of the partners is found NOT to be a real estate professial, will only his share of the proceeds be at risk of tax/penalties, or will the entire partnership be?
Thanks!, Phil
July 8th, 2010 at 10:58 am
I’ll just assume that this is an LLC and you have two members. There would be a question as to whether the LLC is manager-managed or member-managed, but setting that question aside, the bottom line is the LLC is simply a pass-through entity.
Each member gets a K-1 and for one the loss may be deductible and for another it might not be. So, if one has to suspend the loss, it doesn’t mean that the other one will have to. The real estate professional designation is an individual test, not a business test.
The other issue is whether there is 500 hours of material participation per property. If not, and there was no aggregation election made, there could be an additional issue.