Real Estate Professional Loophole

Earlier this year, the tax court issued a decision about the real estate professional loophole. A dentist, one Dr. Zarrinnegar, had used the real estate professional loophole to deduct large real estate investment write-offs. The IRS called “foul.” And their argument ended in court.

If you’re a real estate investor trying to make the real estate professional loophole work, this case provides several really interesting insights. Accordingly, I want to talk about the loophole, about my own professional experiences with auditors trying to arbitrarily close the loophole, and then about how taxpayers who want to use the real estate professional loophole need to organize their real estate and bookkeeping activities.

Reviewing the Real Estate Professional Loophole

Let me start by quickly reviewing the real estate professional loophole.

Most high income taxpayers can’t immediately use the passive losses generated by direct real estate investments as deductions. Valid deductions for depreciation, for example, get limited and “carried forward” to the future.

However, for these high income taxpayers—high income means anymore making more than $150,000 a year—a loophole exists. If the taxpayer or the taxpayer’s spouse spends more than half their time on real estate and more than 750 hours, the usual passive loss limitation rule doesn’t apply.

Note: If you’re interested in the nitty-gritty details of the real estate professional loophole, you may want to refer to the actual Sec. 469 statute or the Sec. 469 regulations which flesh out the details.

Dr. Zarrinnegar’s Real Estate Activities

Dr. Zarrinnegar used this rule to justify claiming gigantic deductions on his and his wife’s tax return. Over $200,000 a year for the years the IRS audited.

To make a long story short, the IRS came in, looked at his four rentals, looked at the dental practice he and his wife (another dentist) operated, and said, “No way.”

Why the Real Estate Professional Loophole is a Big Deal

You want to read this tax court case (click here) if you’re in a similar situation, but Dr. Zarrinnegar’s tax planning gambit was, on its face, a really clever approach. And tax accountants regularly see and help their clients implement similar real estate investment strategies.

What makes sense—and here let me simplify—is that a high income taxpayer making, say, $400,000 a year can invest directly in real estate. This real estate may be returning an attractive return if the property appreciates. The real estate may even be generating positive cash flows. But on the tax return, the tax accounting that goes on (especially the depreciation deductions) may mean the real estate investment shows losses and reduces taxable income and income taxes.

Note: In other posts (like the one here), we’ve talked about how direct real estate investment can work just as well as tax-deferred retirement accounts. You might want to skim that post if you get interested in this subject. Also note that typical taxpayers (those making less than $100,000 a year) have another easier real estate loophole they can use to put deductions on their tax return.

IRS Response to the Real Estate Professional Loophole

In the audit Dr. Zarrinnegar went through, the IRS rejected his treatment. They said, in a nutshell, that they didn’t believe he spent more than 750 hours of time. Even though he produced rather extensive logs. And even though he had explained his business plan to really emphasize his real estate investment activities and hopefully someday enjoy big success.

You can read through the court case to get the gory details (see the earlier link) and probably like me you’ll come away with this awkward conclusion: The IRS just didn’t want to believe the taxpayer’s assertions that annually he had spent more than 750 hours on real estate.

In other words, even though the taxpayer obviously knew the statute’s requirements from the get go and carefully arranged his work to comply with the statute and the related regulations, the IRS auditors refused to believe him.

And here’s another awkward thing about this situation: It appears that this is a common position for the IRS to take. Since the Zarrinnegar decision, our CPA firm has dealt with a similar situation where, in a nutshell, the IRS agent simply refuses to believe that a small real estate investor can spent 15 hours a week ramping up a part-time real estate investment venture.

How the Tax Court Reacted to Dr. Zarrinnegar

Thankfully, the tax court accepted Dr. Zarrinnegar’s status as a real estate professional. The court noted that a “postevent ‘ballpark guesstimate’ is not sufficient.” But then the court also noted that relevant regulations (see 1.469 5T(f)(4) for gritty details) allow a taxpayer to establish her or his participation by “reasonable means.” Not extraordinary means. Not incontrovertible means. Just “reasonable.”

Here’s the language from the IRS’s own 1.469-5T(f)(4) regulation:

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 tax court then pointed out that the taxpayer “provided logs that had been prepared contemporaneously,” that he “offered testimony from other witnesses,” and that he could “testify credibly and at great length about the logs’ contents.” All pretty reasonable, right?

In short, the IRS seemed not to like the law that allows people like Dr. Zarrinnegar to use real estate investment as a tax shelter. Even though the law says they do get to use real estate investment in this manner as long as they follow a more restrictive set of rules than apply to the typical taxpayer.

Final Remarks about the Real Estate Professional Loophole

This blog post has gone on too long. Sorry. But let me quickly sum up three take-aways from the Zarrinnegar tax court decision…

First you can make the loophole work. Even with a start-up real estate investment plan. Dr. Zarrinnegar only had four properties during the years in question. (He was also trying to engage in some real estate brokerage activities by the way.) And the tax court agreed the gambit works—even when the IRS attempted to argue otherwise.

Second, if you want to use the real estate professional loophole, you need the best documentation you can develop to prove your hours of participation. You can’t make after-the-fact, ballpark guesstimates work. The court made that explicitly clear. Rather you want extensive, detailed, contemporaneous logs as well as anything else you can come up with to prove your hours. Ironically, it appears you want better documentation than the IRS’s own official regulations require. (Sorry.)

Third, you don’t need to be the world’s best bookkeeper. Dr. Zarrinnegar’s bookkeeping wasn’t perfect. He bungled some of the accounting. He used some estimates the tax court didn’t like. He didn’t know enough about document storage to deal with the reality that over time ink fades on many receipts. But that didn’t change the credibility of his records that showed he met the 750-hour requirement. The court, in other words, doesn’t require a taxpayer to be a professional accountant.