IRS Audits of Real Estate Professional Status Continue


This post is in: Real Estate
36 Comments

2-03-2011-1

The IRS started auditing real estate professionals about three years ago. In that time we’ve had some cases that help define when you can take a real estate deductions as a real estate professional and when you can’t. But first, let’s go through the details of what it takes to legally take the deduction, and why it’s so important.

Real Estate Paper Losses

As a real estate investor, you already know that one of the biggest benefits is your ability to offset paper losses (primarily caused by depreciation) against your other income. 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.

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.
It’s also important to understand what qualified real estate activities actually are. This has been an area under heavy attack by the IRS in recent years.

Qualified Real Estate Activities

A qualified real estate activity is any activity in which you “develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease or sell” real estate. That doesn’t mean you need to be physically doing construction work, etc. The key is that you perform personal services in these activities. So you could be supervising, meeting, planning, and so on.

The quick list of these qualified real estate activities includes:

  • Develop,
  • Redevelop,
  • Construct,
  • Reconstruct,
  • Acquire,
  • Convert,
  • Rent,
  • Operate,
  • Manage,
  • Lease, and
  • Sell

We cover these items in more detail in the Real Estate Loopholes Home Study Course along with strategies to make sure you’re in compliance.

But qualifying for the Real Estate Professional deduction doesn’t end there. You need to also pass the material participation test. Don’t forget this part! It’s the piece that a lot of would-be Real Estate Professionals get wrong.

Material Participation

The second test is the Material Participation Test. In addition to being a REP, you’ve also got to have material participation on the property. The quick definition is that that means that you have spend 500 hours per property per year. You can make an election to aggregate your properties (so you would need 500 hours per year, spread across your properties), but there can be some downsides to aggregating when you sell. Make sure you check with your tax professional before you make this election.

Update on Real Estate Professional Tax Court Cases

The most significant Real Estate Professional Tax Court cases related to what constitutes real estate activities. The IRS had taken the position that a real estate agent wouldn’t have qualifying real estate activities. Luckily, the Tax Court rulings have been against the IRS.

Lately the IRS has been attacking material participation. For example, if you own your property inside a Limited Partnership, the LP portion is passive. That means there is no material participation. Likewise, if you have a time share or have a property manager who does all the work, you will have a very hard time proving any kind of material participation.

If you get an IRS audit notice, take the time to go through your paperwork ahead of time with you tax representative. Plus make sure your representative understand what it takes to qualify for the Real Estate Professional deduction.

For more information on Real Estate Professional status and other tax breaks for real estate investors, check out Real Estate Loopholes.



36 Comments

  1. Diane Kennedy says:

    Hi Dawn,

    Please contact our office. We can help. https://www.ustaxaid.com/contact/

    Diane

  2. Dawn says:

    Diane:
    I am looking for someone to represent me and my husband for an tax audit. I would like to use someone who is familir with the Real Estate Professional clause. Can you recommend anyone in the New York City area?

    Dawn

  3. wayside says:

    Diane,

    On your Taxmageddon seminar you stated there has been a change to the aggregation election rules and now you need to file an aggregation election every year.

    Can you expand on your comment? When does this take effect? I haven’t been able to find any indication of this anywhere.

  4. David says:

    Diane:
    Is It 500 hours or 750 hours for REP. It is noted differently on your website? Thanks for clarifying. Also, what would be an example of a 3rd party verifying my ancillary W2 for being founder of a company. Also, I was talking to my tax pro. and I asked, does the IRS know that self employed people work about 3000 hours per year, which is what I work. I think IRS agents work 35 hours a week?

  5. Duane Williams says:

    Wayside, I beleive that the time guarding my rentals qualifies under the “operation” of my rentals. The agent disagreed but gave me one of the three years in compromise because having that confirmed in court would not be in the IRS best interest. The hard part is even though I had contemporanious logs they still wanted independant verification of my time spent and I settled on 1 year out of three to avoid what could possibly be an expensive legal fight that I may have lost because I do not have the resources to buy the best legal help just to gain another 10k.

  6. David says:

    Diane:
    can you please explain the provision of owning the real estate business? Is there a difference between owning the business itself and/or having to show a 750 hour aggregrate log?

  7. wayside says:

    “… included time spent guarding them while sitting on my front porch visiting with my neighbors and tenants.”

    Seriously? They accepted this?

  8. Diane Kennedy says:

    Duane, Glad it worked out for you for 2010. And I have never heard about over-sized tires changing the miles either. Great to learn that!

  9. Diane Kennedy says:

    David:

    You need to show a minimum of 750 hours per year in real estate activities and more hours in real estate than any other activity.

    In your case, you will have to prove both the time you spent in real estate activities AND the time spent in the business. Be prepared to show some objective, 3rd party confirmation that you really aren’t working that many hours for the business.

    Please go to http://www.RealEstateLoopholes.com for a webinar on this and other real estate tax and accounting subjects. You’ll need to scroll to the bottom of the page for the webinar. We also have the Real Estate Accountant in a Box featured for a short period at the reduced price of $299. You will find that at RealEstateLoopoles.com as well.

  10. David says:

    Thanks Duane. That is good info., but does not really answer my question about W2 income. I just get a straight salary and benefits for being a founder. Than I sign all the checks the company writes. I read if you own the real estate business 100% then the hourly log is moot if I am understanding correctly. Is that the case?

  11. Duane Williams says:

    Follow up. At the appeal level they allowed all of my previously disallowed miles and 85% of my previously disallowed meals. They allowed REP status for 2010 but not for 2008 or 2009. I felt this deal was better than the risk and expense of legal representation thru a trial. I had 1700 w-2 hours in 2010 but I had logged over 2400 hours on my rentals which included time spent guarding them while sitting on my front porch visiting with my neighbors and tenants. Three of my rentals are within 70′ of my home. The lady in appeals was much more helpful and honest than any of the other IRS people that I had spoken with up to that point. She did note that I was the first to explain that the oversized tires on my truck accounted for why my logged miles were 10% higher than my odometer miles.

  12. David says:

    I have REP designation, but I also have a W2 from a consulting company that I started 12 years ago. The only thing I do for the consulting company is sign checks and spend about one hour every 7-10 days doing so. I get a manila envelop delivered to my office, and I send it back with the signed checks..that is all. Because I founded the company, I get a salary and benefits for this small amount of work. I own a property management company too, several real estate properties, owned in LLC’s and I flip properties for gains and losses in an investment LLC. I spend all of my time on managing my real estate rental activitie, property management and flipping properties. I also get a 1099 from real estate commissions too. The IRS is questioning my status. Because I own these RE companies, property management company and RE investment LLC’s will I be okay as an REP? How do I explain the minor work I do for the W2 income.

  13. sanclare says:

    i am in the middle of an audit and the problem seems to come down to the word “acquire” which is an allowed activity. however, the examiner is disallowing REP due to hours because he says that pre-ownership activities don’t count. Acquisition is, by definition, a set of preownership activities correct?

  14. Dale says:

    I just got an audit notice for 2007. They are zeroing in on my Passive Activity Loss. I am a pilot and earn over $150 per year. Why would they want a copy of my previous year Form 8582? Also can you elaborate on what you previously mentioned about aggregating rental properties. I currently have 7 fully furnished executive rental properties where I provide and pay for everything.

    You said, “(3) Must have material participation of 500 hours per property unless you aggregate.

    This last one (3) seems to be what the IRS is focussing on now. I’ve heard of a lot of people who have lost on that unfortunately.”

    Thanks! Dale

  15. Diane Kennedy says:

    And here is the link to the ATG the examiner was supposed to have used:
    http://www.irs.gov/businesses/small/article/0,,id=146326,00.html

    Scroll down about half way and you’ll see the discussion of 750 hours for REP and 500 hours per property.

    If you did not make the aggregation election, it is possible to do that in the examination.

  16. Diane Kennedy says:

    WOW Duane! No, there has been no change in the number of hours. It’s 750 hours or more in real estate activities and more than any other trade or business. The 500 hours is the material activity requirement.

    Are now in Appeals? I will post a link to the ATG on this matter, it might help to point out exactly what the training they are supposed to have tells them to do and ask.

    And I’ll go look for that case in 9th.

  17. Duane Williams says:

    I was recently audited by the Las Vegas IRS office. I expected to be audited by an intelligent knowledgeable examiner who was familiar with the tax laws. Instead, what I encountered was a poorly trained examiner who started by following the audit guide and then deviated to fantasyland and said that I needed 750 hours per property to qualify unless I previously elected to aggregate them. I pointed out that perhaps he was confusing the aggregate election for material participation. He became visibly irate that I would attempt to correct him and to show his supperiority he denied all my real estate miles and meals without basis even though I have a daily log and comply with the bookkeeeping requirements to substantiate both. Weeks later I sat through the managers review and his manager repeated the same line; “you do have to have 750 hours per house to qualify”. I immediately wrote this down for later reference and this caused his manager to become visibly irate and he told me he was going to issue me the 90 day demand letter and basically threw me out without even reviewing my meals and miles. A week later he sent me the referral to appeals?(note; I was calm and courteous throughout both meetings while both the examiner and the manager were raising their voices to emphasize their point.)

    Is there some case law that changed the rules on the 750 hour rule? I know about the requirement to have more hours in R/E activities than other jobs so please do not reply with that.

    Also, can someone cite the cases that the 9th district has sided with a realtor/salesman being the same as a broker?

  18. wayside says:

    ^ The first test is ‘Must have more hours in REP activities than any other trade or business’.

    So you would need more than 1550 hours of real estate activities to pass this test. And that’s assuming the IRS doesn’t count your vacation time in with your W-2 job hours, because you are being paid for it.

  19. Joanne says:

    Hi Diane,

    I am a Real Estate Investor, with 9 rental units. I filed as a REP. I also have a full time job where I receive a W-2. I have a flexible work schedule there, but have to maintain 40 hours a week. I have been there very long & have a great vacation benefit. So I work about 1550 hours a year there. I maintain a journal of all my RE activities, from repairs to shopping, to garbage & snow removal & it is over teh 750 hours. It is even slightly over my other office jobs hours about 1590 a year. I always felt safe because I documented my work. Today I got an audit notice from the IRS. Should I be scared because I do get a W-2 for a full time job. If I show them my vacation schedule and days worked there and teh RE activities logs wil that be enough? Or can they simply reject my REP status because they thing it’s too much for someone to do? Are there are precedent cases I can refer to? Any advise please?

  20. Duane Williams says:

    Hi, Can you cite one of the district 9 cases were a salesman was treated the same as a broker?
    I am on my way to appeal and that is crucial to my presentation.

    Thank You

  21. Maria Wolf says:

    So I came up with over 800 hours on the property and they still say I don’t materially participate and that my duties were investor (apparently they think that my checking on other rentals listed on the same for rent by owner site I use is investor related==I don’t look up what my property is worth as I don’t want to know how much it has dropped in value)and administrative–excuse me but aren’t the duties that a management company do are administrative–someone needs to have a test case where there isn’t a management company–I guess the IRS feels that the tenants on my property fall from the sky, write their own leases, deposit their rent checks in my bank. We are now appealing the auditor with her supervisor.

  22. Tom MacAleer says:

    Dear Diane,

    I own a few rental properties, have a regular job and make above the 150k phase out for the $25k active participation. I was married in 2010 and my wife was a new struggling real estate agent. She had been licensed but never made any income. She now manages my properties and would meet any of the tests but has no other appreciable real estate activities than our rental properties. could I now deduct my real estate losses against my regular income?
    Thank you!

  23. Maria, there are actually three parts to the REP loophole.

    (1) Must have more hours in REP activities than any other trade or business

    (2) Must have minimum 750 hours

    (3) Must have material participation of 500 hours per property unless you aggregate.

    This last one (3) seems to be what the IRS is focussing on now. I’ve heard of a lot of people who have lost on that unfortunately.

  24. Maria Wolf says:

    My question is if you are a licensed real estate agent/1099 income only–no w-2 income and have a rental property which you rent out weekly (resort property) and you do not hire a management company–you do all the leases/contact with inquiries/send leases out/send keys/return security deposits are you still required to prove the 750 hours per year per property? I thought the 750 hours only applied if you had another job and were trying to show you were a “real estate professional” without being a licensed agent.

  25. Correction – meant to say the tip was to NOT file with a Sch C or E.

  26. Charlie, totally agree that is a crazy statement and besides I don’t see what the relevance would be. The issue is how much time the taxpayer spent and not another party. If taxpayer can prove he has active participation (because this is a business, not a passive real estate investment), then it seems like the auditor is going down the wrong track.

    I’m guessing the issue is that this might be one of the newer auditors and he/she is just following the ATG without thinking it through.

    I’ve got a teleseminar on Sat “25 Stupid Things That Can Cost an IRS Audit”. One of those tips is filing with a Sch C or E. The issue is that most of the IRS’s new hires are non-accountants. That means they can ONLY audit Form 1040 and the schedules. They have to be trained as an accountant to decipher the balance sheet, M-1 and M-2 adjustments that are part of the Form 1065, 1120 and 1120S. That’s just how the hierarchy at the IRS works.

    So it just stands to reason if there are more auditors in one area, there is going to be more audits in that area.

    Nobody like audits, but give me an educated auditor any day. A lot of these issues like this would go away, I believe.

  27. Charlie Way says:

    > but taxman says they consider a management company to have spent 40 hrs/wk on every home they manage

    This seems like a blatantly unreasonable assumption, could this really hold up?

    Somehow, when I claim I manage my own properties, I don’t think the IRS will let me claim 40 hours/week.

  28. Sorry you’re going through that Roger. First of all, I’m glad there is no question that the real estate is not passive in this case, but you have a business. That means you have the lower standard of ‘active’ participation rather than material and like you said, that means 100 hours per property.

    I’m surprised that they are challenging that you don’t have have the 100 hours, but it does sound like this auditor is coming straight out fo the Audit Technique Guide (ATG) for real estate audits. They are told to argue that if there is a property management company. Your challenge is to prove that you have 100 hours of ACTIVITY regarding the properties. Even though there is a management company, what have you personally done to develop, repair, lease, etc the property?

    I’m not sure what the purpose of trying to put the properties in with your other business would be. It sounds from what you’ve said that the challenge is not on your business creating REP status but that you have the active participation needed for those particular properties.

    Good luck! If you don’t get a good result from the audit, appeal it. That doesn’t cost anything and you can sometimes settle it out.

  29. Roger says:

    My wife and I were just audited for our 2007 return. Taxman couldn’t believe we were real estate professionals (duh, no W2 income and all we did was develop residential green homes). The tricky part, which isn’t settled yet, is that our development company, call it AP, is our REP operation but we also own 4 beach rental homes in the OBX. These are all owned in our personal names and we are claiming material participation in these homes which, according to the IRS rules themselves, require us to only put in 100 hours per home or more than anyone else (under the section that these rentals are a business and which we can substantiate). We have two obstacles here. One is that we have a management company who has given us a letter of their hours spent on our homes (< 100 per home) but taxman says they consider a management company to have spent 40 hrs/wk on every home they manage (the employees would be wowed by this…and underpaid!). The other is that he is claiming that these are part of our REP operation when, in fact, they are not. There is no combining of the operations and we have clear ownership separation.

    Stay tuned.

  30. Clint says:

    Wow that really sucks Diane! Goes to show that sometimes the best service you can do for your client is biting your lip, even if it doesn’t give them the best results it prevents any unnecessary tension with the auditor.

    That’s why Audit Reps are so tricky, it’s just like getting out of a speeding ticket- it depends on two things: 1) how much you violated the law, 2) the mood of the enforcer.

    In the case of your client it looks like the answer to 1 was “it wasn’t worth fixing the auditor’s error on this issue at the expense of not resolving the issue actually being audited” and 2 was “he was a complete jerk- a la the cop who writes tickets just because he can.”

    This also goes to show that any tax service that “guarantees” you will never get audited is completely full of it. Tax loophole strategies, while fully legal, still attract the attention of the IRS. The difference between services like yours and ours is that we will fight for our clients if they end up in that situation where as the other places that make “guarantees” are just making empty promises.

  31. Charlie Way says:

    Diane,

    The list of tests is listed in the Passive Activity Loss Audit Technique Guide in the Material Participation section on the IRS web site:

    http://www.irs.gov/businesses/small/article/0,,id=146837,00.html

    Do these not apply to REPs?

  32. Diane Kennedy says:

    Clint, I was doing IRS representation work for one of my clients ( no change audit 🙂 ) – and even though he wasn’t being audited for real estate losses, the auditor told me that he was the new ‘head’ in his office on real estate losses. He’d come to the conclusion that real estate agents couldn’t take the loss. I didn’t say anything because I would never get in a fight that didn’t benefit my client at the time, but I couldn’t believe he said that. We’ve had at least two District 9 decisions that say he’s wrong and he IS in a District 9 office. (Sometimes they can get away with that if they’re in a different District, but even then, precedent is precedent.)

  33. Diane Kennedy says:

    Charlie, those are called the ‘active participation’ rules. In the case of real estate losses, you need active participation to take the $25,000 deduction for income less than $100K per year. Interesting, but I haven’t heard anything about audits for active participation. Boy, I hope we just didn’t give the IRS some ideas because I bet most people just blindly take the ‘up to $25,000’ write-off without considering active participation.

  34. Charlie Way says:

    What about some of the other material participation tests besides the 500 hours? Have any of those withstood an IRS REP challenge in court?

    – The taxpayer does substantially all the work in the activity.
    – The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
    – The taxpayer materially participated in the activity in any 5 of the prior 10 years.
    – Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

  35. Clint says:

    Another great article Diane!

    I thought it was 960hrs or material participation? We advise clients that if they average 20hrs/wk x 50wks/yr then they can qualify. Just to be safe.

    On that note we had a recent case where an RE pro got audited and was handed a $30k tax bill based on an “estimated” return done by the IRS going off of an industry average based on average income in their area. Needless to say, said client did not even earn $30k and we were able to settle this situation for a fraction of what the IRS wanted 🙂

    Another reason why we love doing what we do!

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