Real Estate Professional status is definitely a red flag audit condition, especially if you live in California. If you are currently taking this status, or are planning on it, here are some of the things that you must know.
The Real Estate Professional status allows you to take a full deduction of real estate losses against your other income, regardless of the amount of the loss and the amount of your income. WIthout this status designation, you’ll lose part of the deductibility with it completely phasing out once your adjusted gross income hits $150,000.
WIth today’s less friendly IRS atmosphere, the number of audits is on the rise. And one of the targets is the Real Estate Professional status. Over the past few weeks, we’ve received calls and emails at the TaxLoopholes office from CPAs and taxpayers who have gotten caught in an audit. The IRS auditors appear to be aggressively trying to shoot down the Real Estate Professional status.
Thanks to the Freedom of Information Act, I was able to locate the IRS audit guides that the auditors use when conducting these audits. Here are some of the question you’re likely to get asked.
From the Auditor’s Handbook:
Exhibit 2.5: Real Estate Professional: Interview Half Personal Services Test
_____ Describe the work you perform as a real estate professional. Check occupations by signatures and W-2s.
_____ Who is the real estate professional, you or your spouse?
_____ Does the spouse claiming to be the real estate professional work full-time or part-time? If the taxpayer has a full-time job working 2080 hours a year in a non-real property business, he must work 2081 on his real property businesses to meet half-personal services test!
_____ What percentage of each real property business(es) do you own? Unless taxpayer owns 5 percent or more, time is not counted. See IRC § 469(c)(7)(D)(ii). If, for example, the taxpayer works full-time for a construction company, but does not own any of the company, he is not a real estate professional.
750 HOUR TEST
Time does not count for purposes of the 750 hour test and the half personal services test – unless the taxpayer materially participates in the activity. One spouse ALONE must meet the 750 hour test.
_____ Who performs the services, husband or wife? Hours by husband? Hours by wife?
_____ Approximately how many hours did you spend working on your rentals in the year under exam? Ask the taxpayer for supporting documentation (appointment books, diaries, calendars, logs, etc.) You may want to give taxpayer a log to be completed for each rental – and for each year under exam. Material participation is a year by year determination. Rentals are generally not time intensive.
_____ If non-working spouse claims to be the real estate professional, ask what other commitments he/she may have. Is the spouse a student? Is the spouse providing full-time care to young children?
MATERIAL PARTICIPATION IN THE RENTALS
_____ Who monitors the rentals? Who collects the rent? Who does the repairs?
_____ Do you have a real estate agent or manager or employee responsible for any of the rentals? Ask for each rental property. Check Schedule E properties for large commissions or management fees. Also check for large labor expense – possibly a hired contractor spent more time than taxpayer. If there is paid management, it is a strong indicator taxpayer did not materially participate.
_____ Is anyone besides you involving with managing or overseeing any the properties? Does a relative or friend manage/monitor the property for free?
_____ Does a tenant receives free/reduced rent for managing the rentals – or for caring for the properties?
Based on the above, it looks like they will likely challenge real estate activity time where there is a property manager involved. From another IRS authoritative source, here is their definition of what does NOT work:
While the taxpayer may have spent time working on various aspects of the activity, certain hours do not count in the tests for material participation:
Investor-type activities do not count unless the taxpayer is directly involved in day-to-day management or operations. The Reg. § 1.469-5T(f)(2)(ii)(B) provides that the following types of activities do not count unless the taxpayer is directly involved on a day-to-day basis in management or operations:
Studying or reviewing financial statements or reports. Preparing or compiling summaries or analyses for the individual’s own use. Monitoring finances or operations in a non-managerial capacity. The above list is not all inclusive. Other activities could be investor-type activities such as organizing records, preparing taxes, and paying bills.
Work not ordinary done by an owner is not counted if it is claimed in an effort to avoid the passive loss limitations. This would be work performed by an owner that would normally be assigned to an employee. Generally the taxpayer/owner has no reason to include these services in the hourly computations other than in an attempt to avoid disallowance of losses under IRC § 469.
Travel Time generally should not be considered in computing the hourly tests for material participation, particularly if other factors indicate the taxpayer is not participating in the activity on a regular, continuous and substantial basis.. Legislative history provides that “services must be integral to operations”. It is somewhat difficult to construe that travel constitutes “services” or “participation” as contemplated by Congress or the Regulations. More importantly, travel is not integral to operations in most cases.”
I’m currently interviewing CPAs who have successfully upheld the Real Estate Professional status for their clients. I wish I could tell you there was a great track record in this area, but I’m not finding it.
So far, the one successful argument won on appeal was for a an out-of-state investor who resided in California and was developing a property in the State of Washington. He was able to prove that he actually was hands on based on travel records and pictures of him at job sites, wearing a hard hat and looking like he was supervising.