The IRS started auditing real estate professionals about three years ago. In the beginning some of the IRS claims were really far-fetched and unfortunately for a few taxpayers, it took winning at Tax Court (and paying tens of thousands in representation fees) to prove the IRS was wrong. But now that the IRS has lost a few, they’ve changed tactics in these audits.
First, let’s look at what a Real Estate Professional actually is, in the eyes of the IRS, and why it can mean big tax savings if you qualify.
Real Estate Paper Losses
Face it, you don’t buy real estate planning to lose money. Well, at least you don’t plan to lose REAL cash flow. Still, it happens. Much more likely, especially in today’s new real estate world, is that with the help of depreciation you create a paper loss. A paper loss refers to what happens when you have a taxable loss, but still have cash flow. Either way, you have a real estate loss. Now what?
If you (or your spouse, if you’re married) can qualify as a real estate professional you can offset 100% of your paper real estate losses against your other income. If you can’t qualify, your offset is limited to $25,000, as long as your income is under $100,000. Once your income exceeds $100,000 that deduction begins to decrease as your income rises. By the time your income hits $150,000, the $25,000 deduction is gone altogether. But that doesn’t mean your paper losses go away. They are simply suspended. When you eventually sell the property, you’ll be able to deduct all the suspended losses from your sale proceeds. And in some cases, you’ll be able to take the losses even without selling the property.
What is a Real Estate Professional?
You’ve got to meet certain tests to qualify as a REP, or real estate professional. First, your status is based on hours that are performed in real estate functions. There’s a minimum of 750 hours per year to qualify. If you do other things besides real estate, you’ve got to hit this 750-hour threshold, PLUS you must spend more time in real estate activities than in any other paid activity to qualify. That’s why it’s very difficult for people who work full-time to earn REP status. The IRS doesn’t think it’s reasonable for someone with a full-time 40+ hour/week career to also spend that much time in real estate.
You can also qualify as a REP if you own more than 5% of a real-estate related business. If you’re a real estate agent, you are probably being paid via 1099. That means you qualify. You don’t need to own part of the real estate agency. But if you are paid a salary and receive a W-2, then you do need to own 5% or more of the agency to qualify.
NOTE: This is one of the areas that the IRS challenged, claiming that a real estate agent’s time wouldn’t qualify. This was appealed to District 9 Tax Court and the IRS lost.
Tomorrow we’re going to look at the NEW audit focus the IRS is making when it comes to real estate losses.
Before you take a Real Estate Professional deduction, make sure you meet ALL the rules. We’ve just updated our highly popular “Tax Strategies for Real Estate” . You’ll find the details of what it takes to legally take the Real Estate Professional deduction plus strategies to create even more write-offs.