IRS Strikes Gold with Real Estate Professional Audits


This post is in: Business, Real Estate
6 Comments

5-9-11

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.



6 Comments

  1. Nicole says:

    Question – if one spouse owns property in their name or via a single member LLC disregarded entity, and the spouse without an ownership interest meets qualifications of being a real estate professional, can the losses be fully deducted?

  2. Diane Kennedy says:

    On the surface of it, Jean, you’ve got to wonder what on earth the IRS is thinking.

    The things I would be prepared to show: (1) Proof that you are a full-time real estate agent. Bring a copy of your license and show proof of your income. The IRS was originally trying to claim that a real estate agent was not a qualified real estate activity because the law read “broker a deal” and they said you had to be a broker to broker a deal. They lost at least once in District 9 on that one. If you are in Dist 9, you can use that case, otherwise, you can still use it, but you can still rely on it. Have your CPA look for cases specific to your district and be ready with those cites.
    (2) Proof that you have no other trade or business for which you are paid that is MORE hours then your real estate activity. I know it’s hard to prove a negative, but in this case, if you don’t have any other trade or business, just say so.
    (3) Proof of the >500 hours on management. Pull together any kind of 3rd part proof – schedules of meetings, timeline, timesheets, pictures, whatever you can find.
    (4) Proof that you made the aggregation election so that you don’t have to have >500 hours per property. The IRS is now allowing late elections for that, though. IF you do make that election, remember if you sell at a loss that you need to either suspend the loss or de-aggregate with cause first.

  3. Jean Fletcher says:

    Hello,

    IRS is examing our 2009 federal tax return. They are asking the supporting records for Passive Activity Loss Limitations.

    I’m a full time real estate agent since 2007. In 2009, I received $93345.47 1099-MISC from my real estate firm. The total commission in 2009 was $93345.47 + $23,000 (the real estate firm cut) which should had approved that I worked almost every awaking hour in real estate business. My husband and I own 5 rental properties and we managerd them on our own. Between two of us have spent over 500 hours on managing all rentl homes. Would our rental loss should be treated as Passvive Activity Loss?

    Thanks,

  4. Brian says:

    Thanks Diane –

    I appreciate your response. You raise very good questions.
    We do have a CPA representing us – I read your site enough
    to know that much 🙂

  5. Diane Kennedy says:

    There are two issues I see here. (1) Did your wife have enough REP hours? If ALL you’ve done with real estate is buy one building, then you might have an issue. The question is whether you were in the trade or business of real estate prior to its acquisition. (2) The bigger question I see here is whether you have material participation. That requires 500 hours FOR the property. It can’t be spent on time prior to the acquisition. But you can combine hours (husband and wife) to meet that number.

    If you handled the audit yourself, you may have an issue because the trade or business discussion didn’t get properly presented. You can appeal within the IRS (before you go to Tax Court) and you may want to do that, but first meet with a CPA to discuss your strategy.

  6. Brian says:

    Diane –

    My wife & I are currently being audited on her ‘real estate professional’ status for 2008. She spent close to 900 hours researching, acquiring, and improving a 12 unit apartment building. Our IRS agent wants to disallow all of her time leading up to our closing (pre-acquisition hours).
    This puts her under 500 hours.
    Is our auditor right or wrong? This is his first REP audit.

    thanks.
    Brian

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