More IRS Issues for Real Estate Professionals
The IRS has clearly struck pay dirt in their audits of real estate professionals (at least as far as the IRS is concerned), and so far it looks like the courts are upholding their audit findings.
If you have a loss with your real estate investments, you can take a loss of up to $25,000 against your income, provided your income is less than $100,000. If your income is more than $150,000, you can’t take any loss. Between $100,000 and $150,000 the loss amount phases out. That is, unless you are a real estate professional.
And people took that real estate professional loophole by the thousands. Unfortunately enough took it that shouldn’t have, that the IRS began targeting real estate investors for audit.
Their strategy is lined out in IRS Survival Guide for Real Estate Professionals with Real Estate Investments. You’ll find selected parts of the new IRS audit handbook along with answers that can get you out of hot water if this happens to you.
One of the first things they’re going to ask you (along with proof of material participation and real estate professional hours) is a copy of the Operating Agreement for your LLC, if your property is held inside an LLC. And then they’re going to look for specific language regarding guaranteed payments and your duties. If you don’t have these duties lined out, there’s a very good chance that you’ll lose the real estate professional argument right away. We’re seeing more and more auditors asking to see the LLC and since NONE of the ones I’ve seen (until now) have had the language they’re now looking for, there are real problems.
Megan from Business First Formations has gone through our Operation Guide for LLCs and updated it for the language you need to have if you’re audited. And it’s on special now along with the IRS Survival Guide along with the new “10 Secrets to Winning the Real Estate Professional Argument.”
If you have real estate inside an LLC, you need this information! And with the Operation Guide for LLCs with Real Estate, you can get this information for a fraction of the amount it would cost you for one-on-one time with an attorney to research and develop it.
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The applicable code section is Sec. 469. Passive activity losses and credits limited.
The IRS audit folks place too much stock in the definition of “Real property trade or business” and do not take the extra step needed.
Subsection (C) defines “Real property trade or business”.
“Real property trade or business”. For purposes of this paragraph, the term ”real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
OK….so “brokerage trade or business” is a ”real property trade or business.” So, the IRS just stops there and concludes that you must be performing broker duties because “Real property trade or business” is defined to mean brokerage trade or business. At first blush, it seems to make sense but you just can’t stop at the definition. You must then insert that definition into the applicable code sections to determine whether one is a “real estate professional.”
OK, so what does Sec. 469 say?
(7) Special rules for taxpayers in real property business (A) In general This paragraph shall apply to a taxpayer for a taxable year This paragraph shall apply to a taxpayer for a taxable year if – (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
The key phrases words in the above code section are:
“are performed are in real property trades or businesses”
and
“services during the taxable year in real property trades or businesses.
The single key word used in the above phrases is the word “in”.
In what? Well….”in real property trades or businesses”.
OK….and the definition of “real property trade or business” includes brokerage trade or business.
So do “real estate agents” perform services IN a brokerage trade or business? Of course, in what else business or trade do real estate agents perform services? A hula-hoop factory? Obviously, there is no other business or trade in which they are performing services other than a brokerage trade or business. However, one need not be a broker to perform services in a brokerage business. Real estate agents, whether an independent contractor or employee, perform services in a brokerage trade or business and share in the commissions set by that brokerage trade or business in which their services are performed.