Whenever someone loses in Tax Court, pay attention. That case has just set precedent for everyone in the same category. There recently was a big loss for someone claiming Real Estate Professional tax status. And now we all need to be a little more careful.
First of all, here is some background:
The Tax Reform Act of 1986 dramatically changed how high income taxpayers could take write-offs for real estate shelters.
If you make under $100,000, you can write off up to $25,000 of real estate losses, provided you have active participation. If you make over $150,000, you can’t write any losses off.
That is, unless you are a real estate professional with material participation. You can then write off all of your real estate losses against your other income no matter how much the losses are or the income is.
It’s a tax strategy, but one you have to follow precisely or the IRS will disallow it. Unfortunately, a lot of people and it looks like their CPAs as well, didn’t understand the rules. That’s led to a lot of IRS audits of the real estate tax professional status.
Here’s what happened in a recent Tax Court case.
Mr. and Mrs. Bugarin owned three rental houses and spent time prospecting for more. Mrs. Bugarin was the one taking care of the property. She was also taking care of two kids. She had no paid employment, so all she needed for the real estate professional exception was 750 hours.
The IRS conducted an audit and disallowed the real estate professional status. The taxpayer appealed and lost. And now at Tax Court, they provided a log to account for the time spent on the rental real estate activities. In trial, the IRS’s attorney asked Mrs. Bugarin when the log was created. She said she recently created it using her cell phone and “Outlook” program.
Wrong answer. The log was not contemporaneous. It had been created after the fact.
The taxpayers had plenty of other information. In fact, they had binders of lists of activities. But at this point the question wasn’t whether she had the hours, it had become a question of whether the logs were proof. If they were created later, they were not proof.
This was further damaged by the fact that the sheets she produced as evidence mentioned a property, but didn’t describe what was done. Some of the sheets listed activities, but didn’t state which properties. And some of them had unreasonable amounts of time allocated. For example, 20 hours was allocated to painting a bathroom.
The real estate professional test is just one part. The second part is that you have to prove material participation. And third, you have to prove that you materially participated in EACH of the properties.
One of the choices for material participation is 500 hours. That’s basically impossible to get if you have several properties. You can make an election to aggregate your properties into a single activity. The taxpayers did not make the election. It is now allowed to make the election after the fact, but at the time, it was not allowed.
According to the taxpayers’ notes, there were a total of 810 hours spent in real estate activities in 2009, the year in question. She said that about half of the time was spent looking for property. That meant that less than 500 hours was available for all of the properties. She clearly did not meet the 500 hours per house requirement, since she didn’t even have that much in total.
Another material participation test is if you do more than anybody else and have at least 100 hours per house. Property A had a total of 45 hours of work. She didn’t qualify here either.
The taxpayers had documentation of hours, but the quality was questionable and did not support material participation. As a result, they lost the real estate professional claim.
That’s bad enough. But if the tax understatement becomes material, you also get a 20% additional penalty, on top of all of the other penalties.
Pay attention to your records. And if you get an audit notice, make sure you get experienced IRS representation right from the start. We talk about strategies to prepare for an IRS audit in https://www.ustaxaid.com/shop/IRS-Survival-Guide-for-Real-Estate-Professionals-with-Real-Estate-Investments.html