Real Estate Professional Loophole CLOSED??
Three years ago I’d have told you that if you paid too much in taxes, you needed to buy more real estate. Today, that advice is just flat wrong if you’re subject to AMT (Alternative Minimum Tax)! Now, it’s even worse if you’re a real estate agent claiming the real estate professional loophole.
Agent Beware! The IRS is Looking for You!
Here’s what the rules were three years ago: If you made under $100,000 adjusted gross income, you can deduct $25,000 in real estate losses. If you make over $150,000, you can’t deduct anything. In between, the deductible amount phases out. The exception is if you’re a real estate professional. Thousands of people then took the steps to legally qualify as a real estate professional. And now, it looks like the IRS is challenging that definition.
A primary target is the real estate agent herself. One of our TaxLoopholes community members reports that he’s currently under audit for taking the real estate professional deduction on his joint return. His wife is a real estate agent, does not have any other job and reports the commissions she receives through her legitimate business. Because she claimed the real estate professional status, they then took 100% of their real estate losses against their other income.
The IRS auditor has taken the position during the audit that because one of the requirements is that she is “brokering” deals, she isn’t qualified because she’s not a licensed broker.
Until Jonathan commented on this tactic, I hadn’t heard about it. But, then I started looking and apparently there have been a few cases of IRS auditors in California taking this position. I know of two cases that are planning to fight it in Tax Court. If they win, we’ll have a precedent that might stop the IRS tactics. But, if they lose, everyone who has claimed the Real Estate Professional loophole based on being a real estate agent needs to be prepared for an audit. Thank you Jonathan for pointing this out! Please keep us posted.
Delicious
Digg
Reddit
TechnoratiTrackback URL for this post:
This sort of begs a question for Colorado real estate agents. In Colorado, ALL agents are licensed as brokers. There are two levels - Managing Broker, and Broker Associate. The difference is that all new agents must work as Associates of a Managing Broker for the first two years of licensing. After that, they may take an additional 24 hours of classwork and become a Managing Broker, or continue indefinitely as an Associate, which is what the vast majority do. So… if having a license is the test, do we need to worry in Colorado at all?
Great point! It seems like the IRS is hung up on the term “broker” and not paying attention to what you’re really doing. I think it’s itneresting that so far it seems to be just California real estate agents that are under fire.
I suspect they want to get some cases out there into Tax Court and are waiting for a ruling. If the IRS gets a favorable ruling, that’s when CO agents (and others) will need to be concerned.
Will you please clarify the rules for taking real estate losses against personal income.
I work a full time job outside of my home rental business. My wife is a stay at home mom so she does not have a paid job. I spend well over 750 hours finding, fixing and renting houses as well as the bookkeeping, but I do not spend more time at this than my full-time job. My wife spends a little time helping with the real estate work mentioned above, but is not close to spending 750 hours at it.
Combined we are spending about 1000 hours in the real estate business, and since my wife does not have other income all of her professional time is spent in real estate, so can we apply the real estate losses against my full-time income? Does that make her a real estate professional?
Thanks for your guidanace, it is very helpful.
There are two tests that an individual must meet:
(1) More hours at real estate activities than other business or job
and
(2) Minimum of 750 hours per year.
So, in your case, you won’t be able to claim the real estate professional status because you spend more hours at your job.
Your wife won’t be able to claim the real estate professional status because she doesn’t meet the 750 hours per year.
Unfortunately, you can’t combine the hours.
Diane,
I and my tax client are scheduled for a small tax court hearing the beginning of June on this issue. His wife is a full time real estate agent and they have real estate rentals where they incurred substantial losses. The IRS disallowed those losses claiming that real estate agents do not fall under the umbrella of real estate professionals, ie not in a “real estate brokerage business”. I read where there are two other such cases pending for tax court here in California. May I contact them and see what their status is? If so, i would like to have their names and phone numbers.
Thank you for your help.
Frank N
What I find interesting about this is it’s my understanding that architects qualify as real estate professionals under the original interpretation of the law!
It reminds me of our first audit in 1988 - we passed on everything she questioned. Until it came to the points we paid on our home purchase. At the time the tax guide said (and I’m one of those people who actually read IRS publications!) something along the lines of “no matter what it is called, origination fee, points, etc., etc., if it is pre-paid interest it is deductible.” I actually made her get her copy out and made her read the passage. Her reply was, and I do quote verbatim, “That’s what it says, but it’s not what it means.”
We are in the processing of appealing to IRS, as we have the same situation. I have a full time job outside our rental business. My wife and I both are licensee, me as broker and she as agent. I spent over 750 hours maintaining the properties and my wife spent over 1500 hours. We were being denied by IRS agent as real estate professional and all the write-off. We have been doing this for 20 years, no issues before. Does the law changes recently ?
What do you think our chance in appealing as our lawyer is still looking into this. Thanks much, and any advice is appreciated as this is a nightmare for us.
Howdy again. I’m still looking for responses to my posting a couple of months ago regarding this Sect 469 issue with real estate agents. My phone number is 661-259-3770. We are going into tax court the beginning of June on this issue. I would like to compare notes and find out what successful arguments have been used by others either in tax court or at the appeals level.
I hope to hear from someone soon.
Frank Norton CPA
Hi Frank,
What we’re finding is that the challenges seem to be localized in California, and in addition to the “broker” issue, the IRS is also taking aim at real estate activities they consider passive: research, education, etc.
I did a bit of online research and came up with references to Philip Panitz, who focuses on Federal Tax Litigation. In one article I read he mentioned he had 11 cases pending on this same subject … here’s a link to his website and bio page http://www.pktaxlaw.com/our_founder.htm. I’m guessing he will have some valuable insights into what’s happening, and why.
I’m not a real estate professional, just a simple guy with a few rentals. I was accustomed to a refund of about $7k/yr until I made what the IRS apparently considers the incredibly inexplicably lucrative move of getting married. Jointly our income is just over $150k so by-by deductions. Frankly without those deductions I can’t make it so I’m considering converting my job to independent contractor so I can more effectively satisfy the RE Pro requirements.
Before I do this, do you think the RE Pro status in general is now uncertain? Or just as it applies to agents who don’t necessarily meet the other RE Pro requirements (hard as that is to imagine)?
PS: I wonder why the IRS gives us any breaks at all if they’re going to threaten audits like this for making legitimate claims. Maybe we should all get out of rentals so the govt can put the refunds they recover into housing projects that can turn into govt run slums. I thought the point of the deductions was to encourage private landlords such that the govt didn’t need to provide housing, but what do I know!
Hi MarkA, I know how you feel. I bought the real estate I did based on the after-tax benefits of legally qualifying for the real estate professional status. To change the rules on something that has such major tax consequences isn’t fair, IMO. If they want to change the rules, fine, but people should be grandfathered in if they followed the letter of the law at the time of making the investment. The kind of real estate investing the real estate professional status encouraged is long-term investing. Without the tax breaks I’d have to sell my properties even in a crappy market and then to think that if I got audited for prior years and they disallowed my deductions…don’t even want to go there.
Unfortunately the IRS seems to be free to make and break their own rules. At a tax audit in 1987 my famous quote from the IRS agent was “That’s what it says, but that’s not what it means.”
I have finally become proactive in contacting my representatives and senators about issues I am passionate about. They usually have e-mail options on their websites and a short, to-the-point, personally written letter can make a difference. You can also find out who is on and chairs the different committees on the topic of concern and write to them as well. Same letter, just to all the different legislators.
Hi Mary100, MarkA, Any update on your case? Hopefully everyone who reads about the IRS action will be calling their congress person to complain. With the housing market in an incredible slump, it seems that the IRS is working to put it in a deeper slump, but that is the government for you.
We just got hammered by the new IRS restrictions for being a Real Estate Professional. The IRS has just finished an audit for my wife and me for the 2004,2005,2006 tax years. We have several rental properties in Missouri. We have been using a CPA as a tax advisor over the last several years. I have felt that he is well qualified with real estate business in order to to help us understand and document the activities that would qualify my wife as a real estate professional. I have a full time job, and we had declared my wife to be a real estate professional. This was her only occupation. Since our joint income has been more than $150,000, we believed that having her qualify as a Real Estate Professional would enable us to take depreciation and other passive losses every year as they have occurred on our rental properties. However, as a result of the audit, the IRS has decided to disqualify her as a Real Estate Professional.
According to the IRS audit team (yes, more than one auditer was involved), over the last three years, the IRS has been researching the topic of Real Estate Professional for quite a while and there is now a very detailed internal IRS publication used by auditers to determine Real Estate Professional status and has now very detailed information about what activites qualify as valid activities for a Real Estate Professional. The IRS audit team used these new standards to review every hour of activity that my wife documented for each year as a Real Estate Professional. It is my perspective that the IRS is really getting on the warpath about Real Estate Professional status. We were very diligent in keeping track of my wife’s activities, recording on a daily calendar every activity that she did in support of our real estate LLC. The IRS went through this diary very carefully, and, according to their new Real Estate Professional guidelines, disallowed many of her hours. They disallowed enough hours so that she no longer had 750 hours of qualified activities each year. As a result, many of our passive losses in each tax year were disallowed.
Some of the activities that were disallowed were: 1. researching the market for new properties (!!!) 2. overseeing repairs done by a contracting company, 3. for those properties where we used a property management company, any coordination with the property management company was not an allowable activity. The activities that were now categorized as unqualified activities have really surprised both our CPA and us, especially that you could not include hours that were spent in search of new real estate investments.
The final ruling of the audit expressly said that in order to qualify for Real Estate Professional status, that someone needed to put in 750 hours in directly and actively managing and maintaining their own properties and tenants, and that it did not include hours spent in working through a property management company. In my opinion, these new standards for qualified activities of a Real Estate Professional means that a Real Estate Professional would have to own quite a few properties. Now, we will be able to claim most of our passive losses for a property in the tax year that we sell that property. However, In the meantime, we had to pay tens of thousands of dollars in back taxes, interest, and penalties for the tax years of 2004-2006. The ruling on our audit sent shock waves through the accounting firm that we worked with. They have now been advising all of their other real estate investment clients about these recent clarifications as to what are qualified activities for a Real Estate Professional. My CPA told me that his firm will be advising a large majority of their real estate investment clients (including virtually all Real Estate Agents and Brokers) that they will no longer qualify as Real Estate Professionals, according to these new guidelines.
I hope this is a helpful warning to others. It was very clear that the IRS wants to be much more restrictive in terms of qualifications for Real Estate Professional status. None of the investors with whom I network will qualify as Real Estate Professionals any longer. This clearly will require ownership of many properties and very active personal management of those properties.
I would be interested to hear about any other audit experiences on this topic. thanks.
I am so sorry this happened to you.
Do you live in Missouri? I have heard of the auditors coming down hard in California and since they typically work one area until they good precedent, I had thought they were staying there.
Do you plan to appeal?
The hard thing is that this just comes on the heels of falling property values in many areas. It’s just one more blow to real estate investors.
I understand they want to change the way the status is qualified, however I don’t agree with their tactic of punishing people that were following the rules at that time. If they want to change the rules moving forward and clearly state what are the new rules from now on, fine with me, I don’t need to like it, I just need to know it. However, if they apply new rules to old filings then clearly there is no way to ever be in compliance. There has to be a way to do something about this.
We got hold of the new audit handbook and are dissecting it as we speak. Look for more info on my blog on Fri.
I checked out the National Association of Realtors website and found no mention of this issue at all. I also did a Google search and almost all of what came up was by Diane on different sites that she writes for. Nobody is talking about this.
I’m going to ask my real estate agent if she’s heard anything anywhere. Also, have her pose the question to the NAR - why haven’t they taken a stand?
I think finding out who in Congress has oversight of the IRS and start a mailing campaign. Diane or Megan, do you know who that would be? Maybe Department of the Treasury?
Ok, there is an oversight committee...amazing what you can find when you use Google! Here is the link: http://www.treas.gov/irsob/
There are supposed to be 7 appointed members plus the Secretary of the Treasury, and the Commissioner of the Internal Revenue Service. However, there are only 5 members listed! I wonder why 2 seats are open?
Correspondence should be sent to:
IRS Oversight Board
1500 Pennsylvania Avenue, NW
Washington, DC 20220
Phone: 202-622-2581 • Fax: 202-622-7944
E-mail: irsob@do.treas.gov
Anyone for starting a grassroots movement?
Okay, does anyone besides me see the irony in the acronym .gov/irsob … I mean the jokes just write themselves.
Except this really isn’t a laughing matter.
Mary, I’m in!
Slightly different e-mail address was listed in the commission's last report:
www.irsoversightboard.treas.gov
Ph: 202-622-2581
Charles A. Lacijan
Staff Director
Maybe this address goes to the Staff Director?
Just quickly scanned the last Report they published...very interesting. Diane and Megan, you definitely want to read it: http://www.treas.gov/irsob/reports/2008/IRSOB_Annual-Report_2007.pdf
Some selected quotes:
"Nonetheless, there is room for improvement. The $290 billion annual net tax gap is cause for alarm in that it is affront to honest taxpayers."
"Over 80 percent of the gross tax gap is caused by underreporting of tax (i.e., by underreporting income or overstating deductions and credits), with roughly half of this amount (including self-employment tax) attributable to underreporting of net business income by individuals. Eighteen percent of the gross tax gap is attributable to underpayments of taxes or failure to file tax returns."
"The IRS must apply the results of its research program to increase the effectiveness and efficiency of its enforcement activity. In selecting taxpayers for audits, the IRS should have a high degree of confidence that an audit is necessary. High no-change rates for audits place unnecessary burdens on taxpayers and waste IRS resources. The Oversight Board expects that the IRS will use the results of the National Research Program (NRP) to focus its audit programs where they will be the most effective. Collection cases must also be worked as effectively as possible, based on the optimum assignment of resources for the expected return and impact on compliance."
"The positive trend in enforcement activity crosses all taxpayer segments, including individuals, small businesses, and corporations of all types and sizes, as shown in Figure 7. From FY2002 to FY2007, the following increased activity was achieved:
• Audits of high-income taxpayers (income over $100,000) nearly tripled—from a little over 100,000 to 293,000.
• Audits of small corporations (those with assets under $10 million) grew from slightly under 15,000 to more than 20,000—about a one-third increase.
• Audits of flow-through partnership returns increased approximately 120 percent—from around 5,500 to nearly 12,200.
• Audits of the largest corporations (those over $10 million in assets) rose from about 8,400 in FY2002 to over 9,600 in FY2007—over 14 percent.
• Automated Underreporter (AUR) contact closures in 2007 (unrelated to the earned income tax credit) were over 2 million—up about 28 percent from 2002.
• The number of Tax Exempt Organization returns examined increased over 43 percent—from nearly 5,300 in 2002 to approximately 7,600 in 2007.
• The number of levies by the Collection function nearly tripled —from just under 1.3 million in 2002 to nearly 3.8 million in 2007.
• The number of prosecutions recommended by the Criminal Investigation unit rose around 44 percent from just under 1,000 in 2002 to slightly over 1,400 in 2007."
LOL - actually, falling off my chair laughing!!!
I hadn't even noticed the IRSOB abbreviation! What a hoot! Ya think somebody would have noticed that and maybe suggested a slight change???!!!
Pronounced as irrrrr……….. SOB
commonly heard after an audit.
Diane, since Anna Escobedo Cabral, the US Treasurer was at your White House Roundtable and is part of the U.S. Treasury Department - and the Secretary of the Treasury is a member of the IRSOB (I laugh just typing it!) do you think your networking could get us an ear to listen to this issue?
We could band together and draft a compelling letter about the changing of the rules after the fact, etc. And that "honest people" (their words!) who followed the letter of the law are now being subjected to unfair audit practices.
andviv said it well:
"I understand they want to change the way the status is qualified, however I don’t agree with their tactic of punishing people that were following the rules at that time. If they want to change the rules moving forward and clearly state what are the new rules from now on, fine with me, I don’t need to like it, I just need to know it. However, if they apply new rules to old filings then clearly there is no way to ever be in compliance."
And jhtiger has the perfect example of an unfair audit.
I would think we could get the NAR onboard, or at least a whole lot of Real Estate Agents throughout the country behind us. What does everyone think? Does a grassroots movement start right here?
Hi - we’ve moved this discussion over to the First Class Lounge Forum. You can access it here:
http://www.taxloopholes.com/connect/forum/first-class-lounge-real-estate/lots-recent-postings-diane-039#comment-2191