You maybe should be if you’re using the real estate professional designation to sidestep the passive loss limitation rules… The IRS sees a real estate professional audit as an easy win.
Let me, therefore, briefly describe how the real estate professional designation works for tax purposes. And then let me explain how the IRS can pretty effectively strip this tax savings opportunity from you.
The details are a little gritty. But understanding them can save you heartbreak and headaches.
How the Real Estate Professional Designation Works
We need to start with an explanation as to why the real estate professional designation matters. And here that is.
If your family income equals $100,000 or less, you can pretty easily put up to a $25,000 real estate loss deduction on your return. Further if your income falls between $100,000 and $150,000, you get to use a sliding scale chunk of that $25,000 allowance.
If your tax return shows more than $150,000 of income, however, you typically lose your ability to use real estate losses to shelter other income.
Say, for example, you’ve purchased a rental property for $1,000,000 and it generates $70,000 a year of rents and $20,000 of operating expenses. That leaves you with a $50,000 operating profit. Which is good.
But a property like this might also also burden you with $30,000 a year in mortgage interest And such a property might generate, say, about $30,000 in annual depreciation.
On your tax return, then, the property generates a $10,000 loss as shown in the simple table below.
|Less: Operating expenses||(20,000)|
|Less: Mortgage interest||($30,000)|
If your income pushes you over that $150,000 threshold, as noted, you don’t get to use that real estate loss to shelter your other income.
Real Estate Professionals Don’t Get Limited
However, there’s a special rule for real estate professionals. If you’re a real estate professional, you can include that $10,000 loss. No matter what your income equals.
And if the loss was $100,000 or even more, yes, you’d still get to include the loss on your tax return.
Who qualifies as a real estate professional? Well, the face of it, the definition works pretty simply.
You need to work in a real estate trade or business, which includes (and here I quote the law), “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
Further, you need to spend at least 750 hours on the real estate trade or business or trades or businesses.
Finally, your real estate professional hours need to amount to more than one half of the time you spend working. If you spend 1,000 hours a year as a real estate professional, but spend 1,100 a hours as a, say, teacher, you don’t qualify.
Okay, the above rules are a little bit tricky. But all in all, pretty straight forward, right? I agree.
And so you might think you can use the real estate professional designation to put real estate related losses on your tax return. No matter what your income, no matter how big the losses.
Unfortunately, the IRS can use a handful of tricks and questionable dodges to prevent you from using the law. And that’s what I want to talk about next.
Real Estate Professional Audit Trick #1: Subtracting Investor-type Hours
A first trap to watch out for? You need to be careful about which hours you include in your tally.
You might think, for example, that you can use any of the hours you spend in your real estate activities. But that’s not necessarily the case—especially if you’re careless.
One category of hours you can’t include, for example, are hours spent doing “investor type” work.
Quoting directly from the regulations (available here), this ”investor-type” activity includes:
(1) Studying and reviewing financial statements or reports on operations of the activity;
(2) Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use; and
(3) Monitoring the finances or operations of the activity in a non-managerial capacity.
In an audit, accordingly, the IRS may use the above regulatory language to subtract hours of time you’ve spent working on your real estate investments doing anything that smells or tastes even similar to the above activities.
Then, before you even know it, you’re failed to hit the 750 hour and more than 50% of your time thresholds. And, boom, no real estate deductions.
But here’s the thing. The IRS shouldn’t subtract these hours if you’re also doing other day-to-day management stuff and involved in the actual operations. Here’s the relevant regulation—and note that what the IRS agents do is ignore the part of the regulation that begins with the word “unless,” which I’ve boldfaced and italicized below
…work done by an individual in the individual’s capacity as an investor in an activity shall not be treated as participation in the activity for purposes of this section unless the individual is directly involved in the day-to-day management or operations of the activity.
So you see the way to sidestep this subtraction: You need to be involved in the day-to-day management and operations–and then be able to prove that involvement.
By the way? I think most small real estate investors probably can’t hit the 750 hours threshold unless they can include the hours that a revenue agent will disallow due to the “investor-type” work rule.
Real Estate Professional Audit Trick #2: Subtracting Management Hours
Unfortunately, subtracting “investor type hours” isn’t the only gambit an IRS agent can use to blow up your tax accounting during a real estate professional audit.
A second trap to watch out for resembles the first trap. You need to be careful about hours which can be labeled as management hours. Commonly, you can lose these hours in a recount of your time, too. (I know, crazy. But stay with me.)
Here’s the problem. The law says, “An individual’s services performed in the management of an activity shall not be taken into account.”
Lots of stuff, obviously, can be considered management. Probably all of the most important stuff you do if you’re investing directly in rental property potentially counts as management.
However, as with the investor-type work an IRS revenue agent may want to subtract from your hours, the law Congress wrote isn’t quite as harsh as what some IRS revenue agents want.
The law says that management doesn’t count unless—well, let me just quote the language so you have the words in case you’re arguing with an auditor. I’ve again boldfaced and italicized the language I’ve found auditors ignoring:
(ii)Certain management activities. An individual’s services performed in the management of an activity shall not be taken into account in determining whether such individual is treated as materially participating in such activity for the taxable year under paragraph (a)(7) of this section unless, for such taxable year –
(A) No person (other than such individual) who performs services in connection with the management of the activity receives compensation described in section 911(d)(2)(A) in consideration for such services; and
(B) No individual performs services in connection with the management of the activity that exceed (by hours) the amount of such services performed by such individual.
To sidestep this subtraction, you see what you need to do: You need to not outsource your property management to a professional property manager. And you also need to be doing more property management than anyone else, including some unpaid individual. (Like a family member.)
Real Estate Professional Audit Trick #3: Changing the Timekeeping Rules
An IRS agent uses a third trick to blow up your tax return during a real estate professional audit, too.
And here that is: They will very possibly change the rules as to how you’re supposed to track your time.
Here by the way are the official rules (as they appear in Sec. 1.469-5T):
Methods of proof. The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.
The time-keeping rules you’ll find being applied in a real estate professional audit, however, may little resemble the above.
My experience? You’ll find an auditor assuming you can’t possibly have accumulated the hours. Which means whatever method you’ve used will by definition fail the “reasonable means” test. And then things will quickly turn ugly.
That language you just read about “reasonable means”, for example? Forget that. The new rule will be “irrefutable evidence.”
That language you just read about “contemporaneous daily time reports, logs, or similar documents are not required”? You didn’t really rely on that, did you?
That language about “approximate number of hours” working okay? No way. Are you kidding me?
Finally, that language referring to something informal like simple “appointment books, calendars or narrative summaries”? Not a chance. What you need (possibly two or three years after the event) is something more along the lines of corroborating statements from other third parties.
So the tactic you use given the above? Ironically, I think you ignore the regulation the IRS wrote to provide you with guidance.
And then you do use a contemporaneous log. Something very business-y. Very precise.
Further, if you have a way to conveniently bolster your timekeeping with third party statements or documentation, you want to do that.
Example: If you spend half a day on site with a contractor making sure the project starts right or finishes right, you probably want to ask the contractor to document that (perhaps on the invoice or in a follow-up email). And then you want to save that documentation.
The real estate professional qualification can be a powerful tax planning tool if you’re building wealth through rental property investments.
But you need to be careful.
You probably want to assume you will need to prove your hours to an auditor.
Furthermore, you need to make sure not only that you’re crossing that 750 hour threshold, but also that you’re accumulating the right sorts of hours and the right mix of hours.
Other Resources You May Find Useful
We’ve got a number of blog posts that cover real estate investment tax accounting.
If you want some more general information about the real estate professional designation, you might find this blog post about a recent real estate professional court case interesting: The Real Estate Professional Loophole. (This blog post also provides links to a bunch of general, often rather introductory articles about real estate investor tax rules.)
This comment for established real estate investors: Successful real estate investors commonly but erroneously pay the Obamacare tax on their real estate profits. If you’ve maybe made this error and want to know how to correctly handle things going forward, maybe check out this blog post: Real Estate Investors and the Net Investment Income Tax.
This tangential comment: Make sure if you’re a real estate investor that you understand how the new pass-thru deduction (available as of January 1, 2018) works: The Real Estate Investor Sec. 199A Deduction. This deduction will be a big deal for some investors
Finally, the American Institute of Certified Public Accountants publishes a really excellent magazine, Tax Advisor, for people interested in the nitty gritty details of the tax law. A relatively recent article, Navigating the Real Estate Professional Rules, is worth reading if you’ve gotten this far.