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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.”