We recently received this question regarding Real Estate Professional status for an ongoing business.
“I formed an LLC with a partner in 2002. The business is involved with real estate (acquire land and develop, acquire existing building fixed up for sale or rent). However, the other partner opted out in 2004 and the business became a “Single member, LLC” with a Single asset on a large acre land. I am in the process of sub-division of the large land to build at least 3 single family homes on it. Mean time the existing commercial property on the land is rented out. I am fully involved in the activities of the property of the land. I make all management decisions, necessary repairs, court appearances if necessary, work with the banks that hold both first and second lien on the investment. I spend over 750 hours dealing with the affairs of this property which qualifies me as a “Real estate Professional” per IRS definition.
Recently, I have been selected for an IRS audit. I substantiated all the line item expenses on my schedule ‘C” for the business as was requested. However, the revenue agent is attempting to proof that this business is a “Passive Activity”. Is he correct? I do not agree with his assessment, please advise.”
Answer: Unfortunately, there is much more to legally taking the Real Estate Professional designation. There are actually three tests involved.
Test #1: Do you spend 750 hours AND more hours in qualifying real estate activities than in any other business?
The activity itself must qualify as a real estate activity plus you need a log that shows you have spent more hours in these activities than any other trade or business. If this is all you do, and the activities do indeed qualify and it’s more than 750 hours, you will pass this test. However, remember this is just test #1 of 3.
Test #2: You must materially participate in the activity. There are 7 ways to qualify for material participation, but if you have a member-managed LLC, you can end up with only 3 ways to qualify or even not qualifying at all. The best type of structure to have is a manager-managed LLC with you named as a manager. If you have the wrong structure or do not meet one of the hour requirements for material participation, you will flunk this test. My guess is this is what the auditor is concerned with. If he feels you have not demonstrated that you have material participation in accordance with the very clearly defined rules, then you will flunk Real Estate Professional status for this property.
Test #3: Each activity and each property must individually qualify under the material participation rules, unless you have previously made an election to aggregate the activities and properties on your tax return. This could also be the issue with your return. If you did not make the aggregation election in that year and failed to show him where you made it in a previous year, he will disallow the election.
The Real Estate Professional status has been more closely defined recently by Tax Court cases and new IRS Treasury regulations. It’s also an area that the IRS is targeting.
Please check out the Real Estate Professional Update webinar at http://www.RealEstateLoopholes.com.
If you’ve got a question, here’s how you can get it answered: https://www.ustaxaid.com/got-a-tax-question/