IRS Cracks Down on Real Estate Professionals
We’re back! After a few long months of planning, developing, bugging, debugging and debugging some more, I’m pleased to welcome you all to TaxLoopholes 3.0. Feel free to explore!
I’ve been doing a lot of strategies lately and that’s put me in frequent contact with the DKAffiliated members. It’s been fun to connect and “talk shop” with other motivated and creative tax professionals, and we’ve exchanged some great ideas. Something that almost all of us have noticed is the increased IRS scrutiny of real estate professionals. Becoming a real estate professional has long been one of my favorite strategies for real estate investors because of the ability to take unlimited real estate losses against their income. Without the Real Estate Professional status losses are limited to just $25,000 per year. To become a Real Estate Professional though, you need to pass some tests, including a time requirement. You’ve got to spend more time doing real estate activities than anything else, and you’ve got to spend at least 750 hours per year on real estate. I always recommend to people who want to claim Real Estate Professional status that they keep a good time log of their weekly activities, and that it needs to be accurate. My DKAffiliated colleagues agree on that point - the time diary is something the IRS is taking a long, hard look at. And a recent Tax Court case I came across today confirmed it. In this case, the taxpayer provided a calendar that established the dates she had carried out real estate activities, but only estimated the amount of time she spent on her rental properties. With nothing more than her estimates to go on, the court found that she had spent only 759 hours performing personal service in connection with her rental real estate business, while she spent at least 780 hours performing personal service as an employee in another trade or business. By not being able to prove she had spent more time on real estate activities than anything else, the taxpayer lost her status and the unlimited paper loss for that year.
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Can the time one spends in attending real estate classes /seminars and reading real estate books be included as part of the 750+ hours / year?
Thanks for your question Ally.
The answer is “kindof.” If you are clearly improving on a business skill you are already using and you don’t overdo it, “yes.”
The problem you run into is if you spend all your time studying and learning and don’t ever purchase a property. Then you clearly aren’t involved in real estate yet, or are doing one of the approved real estate activities.
On the other hand, if you’re rehabbing a property and take a course a Home Depot on how to regrout a tub, you’re clearly involved in a real estate activity. (By the way, I wouldn’t have a clue how to regrout anything.)
The same would be true if you have properties and are either doing all leasing yourself, or are in an oversight position over the real estate leasing agents. If you take a weekend class in real estate contract law, I think you have a good argument that it would qualify.
If you are attending a lot of “how to” seminars and the purpose is to get you started in real estate investing, while helpful, those courses probably aren’t going to count.
If you qualify as a real estate professional, my understanding is that the passive losses from real estate can be used to offset earned income / ordinary income. Is this correct?
Can the RE passive losses also be used to offset short-term capital gains, since ST capital gains is taxed as ordinary income?
A Real Estate Professional can offset real estate passive losses against other income, no matter how much the loss and how much the income. S-T Capital Gains would count in that “other income.”
Before you get too excited though…a couple of caveats. (1) You must materially participate in the real estate. In other words, it can’t be real estate that you solely hold as a limited partner or a time share where someone else does everything associated with the property. and (2) Sigh…none of this works for AMT. This strategy is only for regular income tax planning.
Okay, here we go. We were audited from the IRS today for the year 2005 and it didn’t go well. The IRS field agent is now going to look into 2006.
In 2005, we had a lose in our real estate rentals and also in 2006. Bad years in real estate for us.
My wife, a real estate agent, spends 100% of her time in real estate. She also manages our 9 rental properties. Her professional and personal time is completely in real estate activites and takes her beyond the 750 hours.
The field auditor told our CPA today that a licensed independent real estate agent does not qualify as being a ‘real estate professional’, she’s in ‘sales and marketing’. Only being a broker can qualify her as being a ‘real estate professional’. So her independent real estate agent income cannot be considered as non-passive income. Which means all her entire income can be taxed.
Does this go against the spirit of the law? I’ve read IRS code 469(c)(7), I don’t understand how the field agent doesn’t consider her being a real estate professional.
So basically, we either have to pay retro her taxes for 2005,2006 and 2007 (which I can only imagine) or we pay CPA and legal fees to fight this.
Any thoughts? Thanks in advance.
Wow! I’ve never heard of the IRS making that argument before.
I can tell you what I’d do if I was handling the audit - As your CPA, I’d get a sense of the experience of the auditor. If he is new, I’d ask to talk to a supervisor, before it all went on the record. (I suspect he is new because I have not heard of this change in position by IRS auditors)
If they have made their final determination, appeal it. You still shouldn’t have a big fee to do the work so far. Before you decide to fight all the way to Tax Court (and hopefully it doesn’t go that far), take a look at how much it would cost you to just give up on this one.
I’m trying to figure out why the auditor would have made that determination. Did your wife have another job or business? Did she make any commissions as a real estate agent? Were her hours legitimate and well documented?
My wife did no other job other than real estate. She made commissions as a real estate agent sure, she was a licensed agent in our state. That was her income. Of course all her hours are legitimate.
Here’s an article I found on this subject:
http://www.realestatejournal.com/buysell/agentsandbrokers/20070302-dunham.html?refresh=on
We are so upset. We are talking hundred of thousands of dollars here in taxes we would have to pay. We used every bit of her income to survive from loses these houses in 2005 and 2006 during the downturn.
Of course you’re upset. This isn’t fair or right.
Thank you for including the link on the article. I talked to some of my DKAffiliated CPAs. None of our clients have been hit with this audit. The only time it’s happened was in the case of a contractor in CA who was developing in WA. It was a long drawn out audit, but our client won. One of our Sr CPAs did that case and he can stand toe to toe with the best of them and I think he just wore down the auditor with evidence.
It sounds like that that is the tactic you need here. If she doesn’t have another job, actually made money at it and has hours logged - there is NO REASON why she isn’t a real estate professional.
So, all of that doesn’t help you in your predicament. I’m doing some research on how widespread this issue is as well as a “what to do if you’re audited” blog. Look for that in the next few days.
Meanwhile, talk to your CPA. How much experience does he have working with the IRS? Does he have contacts at the IRS to do a face to face about this issue? Sometimes you get a rookie auditor and they’re a little gungho. That’s when you need an experienced CPA on your side - one who knows people at the IRS.
Is your wife a REALTOR(tm)? If so, contact NAR and see if they have any suggestions or currently lobbying regarding this. (They tend to be very supportive of their members and this is something they’re going to want to nip in the bud.) Is there a Tax Attorney or CPA specialist that they recommend?
You (and other real estate agents) will not want this to become a precedent, so I suspect that there is a pool of resources - we just need to find it.
I’ll follow up here after we discuss with our CPA the audit determination. Unbelievable.
http://www.thetaxbook.com/forums/showthread.php?t=6526
This is a thread from CPA’s on this subject as it relates to Real Estate Professional
“Thanks everyone that replied, however the IRS auditor has pushed the concept that without a brokers license, a real estate sales agent cannot be a real estate professional. I am going to have to go to appeals to defend my client. Additionally, I spoke with Gary McBride - a professor at Cal State Hayward and San Francisco’s / Californias tax expert who has said there is a case in tax court related to this same issue in San Ramon and a case in Petaluma that is on its way to appeals.
The auditor said he went to a national IRS class and that was the official position of the agency. Seems the IRS is trying to make new tax law to increase their collections.”
I just left a message for a tax law professor at Cornell. I’m curious if this is just 9th Circuit specific (ie, California, AZ, NV). All the CPAs that appear to be reporting this are in that area.
My guess is that the IRS is gearing up to win this one (they hope) in Tax Court and create a precedent.
Tax law is formed in a number of ways: Congress, Interpretation by the IRS through Regs, Rev. Rulings, Rev Procedures, and Private Letter Rulings, and Intepretation by the court system. So, we need to pay close attention to what happens at the court level. If you’re in the 9th Circuit and the court in that circuit rules, for example, that an agent counts as “brokering” a deal then you can rely on that. If you live in a different Circuit, it carries less weight but is still a piece of the puzzle.
I don’t know if Jonathan has already considered this angle, but can his wife show she spends more time managing/acquiring/et.al. for their own rental properties as a principal investor than she does as a real estate agent representing other parties in the sales process? If so, then the real estate agent part could become a non-issue for them. It would come down to a finer level of distinguishing which real estate activities qualify for real estate professional status.
Interesting point on the RE activities. I agree - if they’re freaking out about agent duties, what if you just prove 750 hours+ for contracting, leasing, etc… I’ll start another post on Real Estate Activities.
Hi Diane,
I’m new to your website. It’s fantastic, thank you!
Here’s a question about Real Estate Professional hours that pertains both to the “must be a broker” notion discussed here, as well as the first comment below about including hours spent studying as part of the 750+ requirement.
I’ve filed as a real estate professional the last 3 years. During that time, I’ve also studied for and acquired a real estate license here in California. I’ve never included any of the (hundreds of) hours that I spent studying to acquire my license as part of the 750+ hours (which I accumulated through development, redevelopment, buy/sell, manage, etc.).
In 2008 I’m going to get my broker’s license. Do you think it is safe to count hours spent acquiring the broker’s license as part of the 750+ hours?
Rephrasing the question: Is time spent reinforcing my position that I am a real estate professional countable as active real estate activity? (I rephrase it this way, because if that is the case, then all of the time I spend looking through tax code, working with accountants, etc. — all for the sake of maintaining the professional status — should all count toward the 750+). In fact, does time spent researching tax code/loopholes/law on your website count?
Thanks for your help!
Thanks for your kind comments on the website.
Take a look at my blog post on 12/14/07. You’ll see the list of activities that qualify. Considering that the IRS is looking pretty hard the RE Professional status right now, I think that trying to qualify research time in the hours is risky.
First of all, your website is an excellent resource. I am starting my real estate investment career but I am not going to quit my full time job as software professional for at least 2-3 years. In my job I spend 40*48= 1920 (approx. ) . So do I need to spend more than 1920 hours to qualify as real estate professional ? or do I just spend required 800 hours and I can qualify as real estate professional. I am in process of getting my realtor license. So if answer to above question is no, is there any other way I can take all the losses from my LLC to my personal taxes? Our family income is around 250k per year?
Hi Diane -
Kudos as well on the site - you’re very pleasant, thorough, and helpful!
As a corollary to apsk’s query above, I work as a commercial real estate lender with one of the country’s largest banks. I spend about 50 hrs/wk (~2500 hrs/yr) lending money to real estate investors and developers to finance real estate investment and development projects throughout the country. I do not own 5% of the company (I wish!).
All of my working hours with the company are spent “in real estate,” though not in development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or sales. I personally own 5 rental properties, however, and spend about 800 hours a year of my personal time, outside of the bank, in various of these activities in association with these properties.
Does my lending work contribute to the definition of a Real Estate Professional, or hinder me, i.e., do I need to work a great number of hours managing the rentals than I do as a lender?
If I do qualify as a real estate professional (please ignore the question if this is not the case), do I need to form a corporation or LLC to manage, own, etc., the properties, or can I continue to do all of this in my personal name?
Many thanks!
apsk: Unfortunately, you’re right. If you work 2000 hours at a “regular job” you’d need to work 2001 hours in real estate activities. If you can’t qualify, could your spouse? I have a thread going in the First Class Lounge Forum on exactly the issue that you have going here - high W-2 wage earner and real estate loss.
http://www.taxloopholes.com/connect/forum/first-class-lounge-tax-loophol/two-high-w-2-wage-earners-amp-
jdbrew: If you work in real estate activity, but don’t own 5% or more of the company, it doesn’t count. I know that doesn’t even make sense, but that’s the rule. So, in order to take advantage of the real estate professional status, you’d have to spend at least one hour more than you do at your full-time job. I don’t know if this is possible, but could you become a 1099 independent contractor with the bank? No matter what happens with the deductibility, it would be better for you to have an LLC to protect the assets though. It doesn’t help with the taxes, but it will protect what you’re building.