Like a large percentage of Americans, I have fought a long battle with my weight throughout my lifetime. I have started and restarted diets many times. The accounting nerd in me has gone as far as creating a spreadsheet to track my daily calories. I’ll do well tracking my eating habits for a few weeks.
Sometimes I find myself cheating a little bit. Maybe I did or didn’t eat the Twinkie after lunch. If it doesn’t show up on my spreadsheet, no one will ever know. I know my training app recorded 500 calories burned from my workout, but it really felt like 600. I had to have burned at least 25,000 calories the day I walked around the state fair. It’s all estimates. Am I right?
You haven’t been redirected to another article. This is the right place. Today I’m discussing qualifying as a real estate professional to take advantage of rental real estate losses quicker than what a passive investor is allowed. My weight challenge is a good comparison to what I often read in tax court cases on this issue.
And it’s one that has seen much litigation through the years. So much I suspect it is the most litigated debate battle in the taxpayer versus IRS saga with the taxpayer losing most often. Why, you ask? I believe the most common reason is failure to document their qualification as a real estate professional. Here’s how it tends to go.
IRS Notice Requesting More Info
Imagine your tax advisor has just finalized your tax return and e-filed it. You get an email the return was accepted a few hours later. You’ve sweated the filing of your return for several months and now you’re done and can move on running your business. But then several months later you get a letter addressed from the IRS. They’re questioning some of your calculations and would like to take a deeper dive into the amounts reported.
No sweat, right? Well, not so fast. Sweat is already beading up on your face as fear grows about whether you properly documented all the positions you took on the return. You recall the great year you and your spouse had as employees in jobs unrelated to the rental business earning $300k. You’ve done well enough over the last few years that you made the dive into purchasing a few rental properties. You began renting the properties early in the year and generated a loss with help from depreciation and the interest expense you paid on a loan. The loss generated is $150k which helped reduce your taxable income down to $126k.
After many back and forth communications, the IRS believes your taxable income should be $276k because they have disallowed your rental loss, claiming you are not a real estate professional. They recalculated your tax liability and included penalties and interest. Their decision is final, but you disagree with their adjustments and petition the tax court to argue your case.
Since taxpayers bear the burden of proving the IRS wrong in tax court, the judge asks for you to submit a substantiation of the hours you spent working on your rental properties. You ask for a few days to locate it. The judge accepts your request and you sprint out of the courtroom directly to your home computer, hastily trying to recall every time you drove over to one of your properties to unclog a toilet, replace a light bulb, or cut the grass. You have a decent memory and feel confident that your hindsight tally of 2,000 hours is as close as you can get to the actual amount you spent that year and submit this list to the court.
Soon the judge issues his opinion – and you’re a loser! A confused and angry one at that. After all, you provided proof! You may or may not eat one Twinkie before calming down enough to read the judge’s reasoning.
It seems you recorded a 25-hour workday for one of the days. Also, the court was able to confirm you spent 2,080 hours working in your W2 job. Remember that vacation you took in July and posted pictures on Instagram? The IRS does – they submitted it to the judge. He’s curious how did you manage to record hours that week for your rental property?
These are examples of similar occurrences in many court cases. My favorite is the one where the taxpayer spent extra time logging hours in a calendar using different colored pens and dripping coffee stains on some pages to make it look more contemporaneous. I can only imagine the judge’s face upon reviewing it and noticing the times recorded looking perfect, but the year of the calendar was not the tax year being appealed!
Document, document, document
Previous articles I’ve written have touched on the topic of documentation. It’s difficult for real estate investors who are stretched thin with other business tasks to worry about currently maintaining a time log that may never have to be presented and will likely only collect dust in a desk. Of course, with today’s technology, there are many app choices to help you record.
You may ask what is required to document your time involved in the business? An IRS Temporary Regulation explains, “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 the period, based on appointment books, calendars, or narrative summaries.”
The taxpayer in my earlier example would have a difficult time proving either one of them was a real estate professional since both worked full-time jobs. But you may meet the qualifications. Make sure you take the time to document.
What is all the fuss anyway about being a real estate professional
Remember in my example the taxpayer had a rental loss of $150k. As a passive real estate investor, they were not allowed any deduction in the current year because their modified adjusted gross income (MAGI) exceeded $150k. (Had their MAGI been $100k or lower, they would’ve been able to currently deduct only $25k of real estate losses. And with MAGI between $100k and $150k the amount would’ve been reduced pro rata.) Therefore, the $150k rental loss they produced in their first year is suspended and carried forward to future years. It remains suspended until their MAGI falls within the above parameters or they sell the property.
If one of them had qualified as a real estate professional, they would’ve been able to deduct the loss immediately. Of course, they wouldn’t likely have had as much W2 wages so any resulting overall loss would be carried forward indefinitely this time being labelled a net operating loss (NOL) to be deducted in future years against ordinary income. (Note: The CARES Act recently allowed NOL’s to temporarily be carried back 5 years.)
Do You Qualify As A Real Estate Professional?
Section 469 of the Internal Revenue Code specifically singles out as a default position that any rental activity is passive unless it meets an exception as follows:
- More than ½ the personal service you performed in trades or businesses during the year must be performed in a real property trade or business in which you materially participate, AND
- You should perform more than 750 hours of services during the year in a real property trade or business in which you materially participate.
You should work predominantly in a real property trade or business such as:
- Real property development
- Leasing; or
Asking the right questions during tax time is very helpful. You may recall in my example the taxpayers used a tax advisor to prepare their return. It is recommended you choose an experienced tax advisor who specializes in real estate to prepare your return and assist with your tax planning throughout the year. Real estate tax accounting can be complicated and require a deeper dive into your current situation than a general accountant may be able to handle.
So, grab a box of Twinkies and get yourself started on the path to real estate professional eligibility by meeting with your advisor and documenting your time spent. You’ll be glad you have a better understanding if the IRS ever comes calling.
If you would like some assistance, please reach out to me.
This article was previously published by the Kentucky Real Estate Investors Association and is reprinted here with permission.