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:
- Lease, and
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.
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.