Why should you even care about whether you are a real estate professional? Well, one reason is that you’ll pay less tax if you have real estate.
Here’s the issue. If your adjusted gross income is under $100,000, you can deduct up to $25,000 of passive real estate losses provided you have active participation and basis. If your adjusted gross income is over $150,000, you can’t deduct any of your losses. Between $100,000 and $150,000, the amount you can deduct phases out.
If you or your spouse (if you are married, filing jointly) is a real estate professional, then you can take all of your real estate passive losses no matter how much the losses are and no matter how high your income is.
There are three parts to the real estate professional test:
- You must have 750 hours of real estate activities and more hours than spent in any other trade or business. If you’re married, you or your spouse alone must qualify. You can’t add your hours together.
- You must materially participate. There is a strict formula for this.
- Each property must qualify individually, unless you aggregate your group.
That’s the short answer. There is a lot more information available on this in the Real Estate Professional Home Study Course.
A recent court case (Penley vs Commissioner of the IRS) had the case of a man who spent 2,912 hours at his regular business. He and his wife were real estate agents and ran their real estate activities through an S Corporation, along with their real estate properties. There was a loss on the real estate, which they treated as a business loss.
That was the first mistake, even if you are a real estate professional, the income or loss is still real estate. In this case, though, the real estate professional would have nonpassive real estate income or losses. It doesn’t become business income or loss.
The second issue is that the taxpayer asserted that he had more hours in real estate than in his business. Since he had 2,912 hours in his job, that would mean a lot of hours.
The problem was that his entire time diary was “ballpark guesstimates.” When he traveled, he rounded up to the nearest ½ hour. In order to work the hours he claimed, he would have to work almost 13 hours a day, every single day for 365 days straight.
He next tried to claim that it was the tax preparer’s mistake and not his. They lost that part of the argument as well. The Court and the IRS are actively challenging taxpayers who claim status as real estate professionals to provide complete and accurate records.
It doesn’t mean that you shouldn’t become a real estate professional. It just means that you need to be very diligent.