Real Estate Professional Status:
Why, When and How to Use This Legal
Tax Loophole
By Diane Kennedy, CPA
If you are a real estate professional and you are paying taxes, something
is wrong. It’s probably one of these two things:
(1)
You don’t own enough real estate, or
(2)
You don’t have the right tax strategy and CPA.
You don’t need to pay taxes. There is one big requirement to this
strategy, though. You must qualify as a real estate professional.
That’s what this home study course is all about. You will learn:
(1)
Why real estate professional status is such an important
loopholes,
(2)
What it takes to legally take this deduction,
(3)
How to avoid 8 real estate professional traps, and
(4)
How to beat any IRS audit of this status.
Real Estate Income and Losses
One of the benefits of real estate is that you can have a property that
provides cash flow and legally also gives you a loss for tax purposes. It’s
the best of all worlds! You get cash flow, appreciation and tax breaks.
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In “101 Tax Loopholes for Real Estate” Home Study Course, you’ll learn
depreciation strategies to regulate the amount of taxable income or loss
you have, as well as other strategies to reduce your taxable income.
In most cases, you can create real estate losses. However, it may not do
you a bit of good as a tax-saving strategy.
If your adjusted gross income (AGI) is less than $100,000, you can take
up to $25,000 of real estate loss against your other income provided you
have active participation in the property. AGI is the bottom number on
the first page of your Form 1040.
If your AGI is greater than $150,000, you can’t take any of the loss
against your other income.
Between $100,000 and $150,000, the amount of loss you can take
phases out.
There is an exception. If you or your spouse is a real estate professional,
you can take all of your real estate losses against your other income – no
matter how much your income is or how much your loss is.
That’s the strategy: Become a real estate professional. Now here is how
you do it. First, though, there is an important distinction you need to
make.
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Is Your Real Estate a Business or an Investment?
The term “real estate investor” gets thrown around a lot. When it comes
to the IRS, though, the term has a very precise meaning. The IRS defines
what you do, how you do it and the resulting tax consequences very
clearly. The definitions also tell you what tax breaks you can legally
take.
WARNING: If you’ve ever attended a real estate tax saving lecture, read
a book on real estate taxes or listened to a home study course, and you
weren’t instructed to first find out what type of real estate investor or
business the IRS has defined you as, run!
Anytime someone tries to put you in the ‘one size fits all’ category, they
are setting you up for a big legal, tax or audit issue.
The fact is that we are not all the same. Our approaches, strategies and
simply the way we conduct business differ. Real estate tax is a
sophisticated part of tax law. There have been hundreds of Tax Court
cases that go to define the type of real estate investor or business owner
you are. If you don’t know what type of investor the IRS defines you as,
you’re just asking for trouble.
The IRS may not even recognize your real estate investment AS an
investment. You could instead have a real estate business. The first
question is: Real Estate Investment or Real Estate Business?
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Real Estate Business
Let’s start with why this is important. If you have a real estate business:
. Any tax losses are business losses and are not subject to passive loss
limitations. (This is huge!)
. You will have self-employment tax of 15.3% unless you have the right
business structure.
• You don’t have to qualify as a real estate professional to take tax
losses.
• You avoid the Affordable Care Act Medicare surtax. There are more tax differences, but those are the key ones for most of
my clients. The benefit of being able to use depreciation to create tax
losses and then use those tax losses against other income is huge. It’s
hard to do these days if you have a passive loss. However, if you have a
real estate business, it’s a business loss, not a passive loss. Do You Have a Real Estate Business? There are two primary ways you could be considered a real estate
business:
• As a real estate dealer, or
• As an owner with real estate rentals that qualify as creating active
income, not passive. A real estate dealer buys property for a quick sale. If you fix-n-flip or
wholesale properties, you are probably a real estate dealer for those
properties.
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This is one of the confusing things about the definition. You personally
are not labeled a real estate dealer, so that every real estate property
you own is a real estate business. Instead, you have the real estate
dealer designation on just the properties that qualify. You could be a
real estate investor for some properties and a real estate dealer for
others. Only the real estate dealer properties will qualify as a business.
If you have property that you rent out for short stays and provide
substantial services, you will have a real estate business and not a real
estate investment. The most common examples for the short
stay/substantial services landlord are with a hotel, bed and breakfast or
vacation property rented by the day or week.
Strategy for Real Estate Business:
First, understand what properties will be part of a real estate business,
not being held as real estate investments.
Set up an S Corporation or LLC (limited liability company) that elects to
be taxed as an S Corporation. This will avoid the self-employment tax.
The passive real estate investment properties should not be held in the
same entity. Also, remember you want to avoid holding appreciating
properties for long term inside any kind of corporate tax structure.
If you have a property with a big loss you can’t take on your tax return,
can you (and should you) turn the property into a real estate business? 
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Real Estate Passive Loss
If you don’t have a real estate business, you have real estate investments
with passive income or losses.
In this case, we’re concerned about the tax implications of real estate
losses.
<$100,000 AGI and Active Participation
If you make less than $100,000 per year in adjusted gross income and
have active participation, you can take up to $25,000 of real estate
losses against other income.
Let’s take a look at what active participation actually is. It’s important
to note that this is a different standard than the material participation
required for real estate professionals.
Active participation is a less stringent standard than material
participation. As long as you participate in management decisions in a
bona fide sense, you have actively participated in the real estate rental
activity. Activities that qualify may include new tenant approval, rental
terms, repairs, capital expenditures and the like.
According to the IRS Audit Techniques Guide there is not a specific hour
requirement. Even if you use a management company, you will be
considered active if you are involved with the operation of your rental.
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However, you must be exercising independent judgment and not simply
ratifying decisions made by a manager or management company. In
addition, you must have at least a 10% interest in the rental activity.
What is a Real Estate Professional?
If your AGI is over $150,000, you can’t take any real estate loss against
other income. That is unless you or your spouse is a Real Estate
Professional.
Throughout the rest of this course, we will talk about the “Real Estate
Professional” status. In this case, we mean the definition that the
Internal Revenue Code and other instances of tax law specify. It doesn’t
necessarily mean that you are a licensed real estate agent or broker.
There are actually three IRS tests to determine if you are a Real Estate
Professional (REP). You must pass them all. The tests are:
#1: You or your spouse must alone qualify with hours as a REP. You
cannot combine hours on this part of the test. The qualifying spouse
must have more hours in real estate activity than in any other trade or
business and at least 750 hours per year in real estate activities. There
is a list of real estate activities in the next section.
#2: You and your spouse can combine hours for this second test. You
must materially participate in the property. Material participation may
include:
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(1)
At least 500 hours per year in activity with the property,
(2)
At least 100 hours and more than any other person in activity
with the property, or
(3)
More than the hours of all other people combined who have
activity with the property.
The IRS has taken the position that if you have a property manager, you
won’t qualify for the last two possibilities. The only way you can prove
you have material participation is with 500 hours or more.
#3: Each property must individually qualify unless you make an
election to aggregate properties. The downside of aggregation is that if
you later sell one of the properties at a loss, you cannot use that loss to
offset other income.
Qualifying Real Estate Activities for Test #1
Qualified real estate activity is an activity in which you “develop,
redevelop, construct, reconstruct, acquire, convert, rent, operate,
manage, lease or sell” real estate.
Remember that the key is that you perform personal services in these
activities. The IRS has taken the position that acting in a managerial
capacity might not be enough. Make sure your activity log shows detail
of the activities.
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DEVELOP: To qualify for hours in this sub-category:
You should also be involved in actually performing some of the
development work yourself, if you have such skills, or it could be time
you spend hiring professionals, supervising their work, reviewing plans,
and/or inspecting the work.
This development could be anything from subdividing property, with no
additional amenities added, to actual construction of real property.
REDEVELOP: To qualify for hours in this sub-category:
You should be involved in actually performing some of the development
work yourself, if you have such skills, or it could be time you spend
hiring professionals, supervising their work, reviewing plans and/or
inspecting the work.
CONSTRUCT: To qualify for hours in this sub-category:
You should be involved in actually performing some of the development
work yourself, if you have such skills, or it could be time you spend
hiring professionals, supervising their work, reviewing plans and/or
inspecting the work.
RECONSTRUCT: To qualify for hours in this sub-category:
Just as with
“construct,” qualified activities under “reconstruct” are
any that are necessary for this phase of building.
ACQUIRE: To qualify for hours in this sub-category:
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Acquiring a property has many phases – meeting with sales people,
looking at a whole range of properties, preparing an offering,
responding to counter-offers, arranging financing, meeting with
insurance agents, inspections, and actually closing on a property. You
don’t need to acquire a property to rack up a lot of hours in this area.
CONVERT: To qualify for hours in this sub-category:
Conversion of property is similar to redevelopment or reconstruction,
but might have the additional time element of meeting with planning
officials. All of that time counts toward your qualified real estate time.
RENT: To qualify for hours in this sub-category:
The time spent meeting with your property managers to establish rental
criteria, as well as acting as renting agent yourself (including the
showing, screening, advertising, etc.), will count as qualified real estate
time.
OPERATE: To qualify for hours in this sub-category:
If you spend time as a property manager, or meet with your property
manager, then you will spend significant time as the “operator” of real
estate.
MANAGE: To qualify for hours in this sub-category:
Similar to “operation” of real estate, if you manage your property, its
tenants, prospective buyers, etc., then you are involved in qualified real
estate activity.
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LEASE: To qualify for hours in this sub-category:
The time spent meeting with your property managers to establish
leasing criteria, as well as acting as renting agent yourself (including the
showing, screening, advertising, etc.), will count as qualified real estate
time.
SELL: To qualify for hours in this sub-category:
All of the activities involved in selling a property (getting ready for sale,
setting up open houses, placing ads, meeting with real estate brokers
and prospective buyers) count toward qualified real estate time.
It is critical that you keep detailed records of your time spent in each of
the above real estate activities. This is your first and best evidence that
you are properly acting as a Real Estate Professional. If you travel to job
sites or properties, keep a notebook in your car and use it each time you
go out, to record the date, destination and purpose.
If you work in your own business that is not related to real estate, you
will likely also need to prove how many hours you work there. Keep a
log of time there too. You will need to prove you have more real estate
activity hours than any other business activity.
Real Estate Professional Problems
Problem: If you hold property in a limited partnership as a limited
partner, you do not materially participate. You can have the same
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problem if you are a member in a member-managed LLC or a member in
a manager-managed LLC and not named as active.
Solution: We recommend that you hold property inside a managermanaged LLC and name the real estate professional(s) as managers.
Problem: No matter what, the IRS does not allow you to take a loss on a
time share under any circumstances.
Solution: Use your time share as a business retreat for your legitimate
business. (If you don’t have a business, you may want to consider
starting one. They have the best deductions possible.)
Problem: You want to qualify as a REP, but you have a property
manager for your properties.
Solution: You may easily qualify for the first test, hours in real estate
activities, but your challenge is going to be qualifying for material
participation. The IRS has taken the position that if you have a property
manager, you need to meet the 500 hour test. This position, by the way,
is not in the Tax Code or any court cases, it’s just what they’re holding to
in audits. You could challenge it, and set case law especially if you win.
But it’ll be expensive.
The best plan is probably to aggregate your properties and then meet
just one 500 hour requirement. Keep track of your hours because this is
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a weakness that the IRS will try to discover.
Problem: If you’re married, and want to file separately from your
spouse, you cannot take the REP status.
Solution: You need to file jointly or get a divorce. There is no way
around the limitation of married filing separately and REP status.
Problem: You haven’t been able to take losses in the past from your real
estate and so you have a lot of suspended losses.
Solution: Suspended losses are real estate tax breaks just sitting there.
You have a few options now to release those tax savings.
First, if you’re not going to qualify as a REP, reduce losses. There is no
sense in continuing to increase your suspended losses. In fact, it ends up
costing you more in taxes when you sell. The excess loss increases basis,
which reduces capital gains tax. But it means you have to recapture
depreciation at a flat rate of 25%. You’ll pay more in taxes.
There are two strategies for using up suspended losses. You can sell the
property. You will be able to use those losses as increased basis.
Or, if you can get your AGI below $100,000, you can start to eat away at
the suspended losses at $25,000 per year.
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Problem: If you’re trying to pass the REP tests and realize you can’t get
material participation on each property, you should probably consider
aggregation. The problem with aggregation is that if you sell one of the
properties in an aggregated group at a loss, you can’t take that loss
against other income. The loss “stays in the group” until it can be used
against a property that sells at a gain or all properties are sold.
Solution: It is possible to de-aggregate a group. This will require you to
make another election on your tax return and prove that something has
changed with the properties so that they are no longer similarly
managed.
Problem: You can’t use your real estate passive loss no matter what. If
you sell the property, you’ll have to take a huge out-of-pocket loss and
you want to hang on until the market values increase.
Solution: Some of my clients have been able to change their passive
investments into a real estate business by changing to short-term
vacation rentals. It doesn’t work for everyone and in every case, but if it
works, you can start taking those losses against other income. You don’t
need to be a REP to take those deductions.
Problem: You are a real estate dealer, perhaps a fix-n-flipper. You want
to sell a property and carry back paper. Great idea, right? Wrong! It’s a
horrible idea if you’re a real estate dealer. That’s because you have to
pay tax on all of the gain right up front, whether you collect the money
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or not.
Solution: There are a couple of options here. One, if you sold the
property that you had meant to invest with, you’re not a real estate
dealer. In other words, if you fix and flip a house you may be a dealer.
And that means you pay tax immediately on gain. If you fix and flip a
house you meant to hold long term and then changed your mind, you’re
not a dealer. That means you do not pay tax immediately on gain.
That option won’t work if you do a half dozen houses a year. If that’s the
case, you need another plan. Another idea is that instead of carrying
paper (financing) yourself is to set up a rent to own program. In that
way, people are renting from you. Some of the rent goes to buying the
house at a future date. Be careful of your local and state laws for these
programs. There were some bad guys running scams when the real
estate market crashed and so there was a backlash of legislation in some
areas.
You’re Being Audited – Now What?
If you’ve been selected for an audit and your Real Estate Professional
status is being challenged, the IRS will be using their rules to evaluate
your claim.
In this next section we’re reprinting portions of the IRS Audit Handbook,
which is the practice guide that examiners will be using during your
audit. We’ve identified each issue for you, along with our analysis on
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what it means. You’ll also find the questions you can expect to be asked,
and the list of documents you’ll be expected to provide.
Issue: Automatic Adjustments due to Passive Loss
Limitations
IRS HANDBOOK POSITION
Any flow-through adjustment which increases the partner’s Modified
Adjusted Gross Income (MAGI) over $100,000 could result in an
automatic adjustment to rental real estate losses. Under IRC section
469(i), a $25,000 special allowance for rental real estate losses is
generally permitted. However, the $25,000 offset is phased out at the
rate of 50 cents for every dollar MAGI exceeds $100,000. When the
partner’s MAGI is greater than $150,000, no rental loss is permitted
(unless the taxpayer has passive income, which is relatively rare, or is a
real estate professional that materially participated in the rental). MAGI
is simply, Adjusted Gross Income (AGI) computed without any passive
loss or passive income (plus several minor modifiers).
IRS Handbook Examination Techniques
Review each partner’s return for adjustments that will push AGI over
$150,000. If there is any net rental loss on Schedule E line 26, there is a
potential automatic adjustment.
US TAXAID ANALYSIS: The wording above is interesting. “There is a
potential automatic adjustment.” In other words, if you’re showing a loss
here, the IRS is looking for a way to disallow it. Watch for material or
active participation rules first, and secondly, income restrictions.
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Schedule E (page 1)
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Schedule E (page 2)
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Issue: Automatic Adjustments due to Passive Loss
Limitations (continued)
If AGI is over $150,000 the partner’s MAGI is also probably greater than
$150,000. In other words, there is generally no need to compute MAGI.
Furthermore, if the partner’s MAGI exceeds $150,000, there is no need
to compute Form 8582. In the absence of passive income, rental losses
are simply disallowed.
For the report, simply make a statement to the following effect: Since
the taxpayer's MAGI as defined in IRC section 469(i) exceeds $150,000,
no loss is allowable in the current year. Losses must be carried forward
to the next year and entered on Form 8582 line 1c.
US TAXAID ANALYSIS: Unfortunately, some of the more inexperienced
auditors will stop right here and not look for the Real Estate
Professional (REP) exemption. Your representative may need to point
out the rules regarding REP and why you qualify.
Issue: Identification of Taxpayer as a Limited Partner
IRS HANDBOOK POSITION
Check the partner’s AGI to see if it is less than $150,000. Then check line
26 of Schedule E to see if there are net rental losses. Also check Form
8582 line 1 to see if there are any rental real estate losses.
US TAXAID ANALYSIS: This portion of the IRS Auditor’s Handbook is
taken from the partnership section. The IRS will be looking for individual
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taxpayers who are taking losses by tracing through the Form 1065
(Partnership Return).
If there is a Form 8582 attached to the return, check lines 1a and 3a to
see if there is any remaining passive income. If the figure on line 16 is
the same as the sum of line 1a and 3a, the taxpayer has used all his/her
passive income. In some cases, Form 8582 is not filed. However, passive
income is reflected on Schedule E line 24 and on the back of Schedule E
in the passive income column (g).
The examiner can easily tell whether the taxpayer is a real estate
professional. If Schedule E line 43 has an entry, the taxpayer claimed to
be a real estate professional.
Also verify that the taxpayer is not a real estate professional via review
of Schedule E line 42. If there is an entry on line 42, the taxpayer may
not be subject to the passive loss limitations.
US TAXAID ANALYSIS: This is an error in some do-it- yourself software. It
allows the preparer to override or directly enter a loss. If the income is too
high and the real estate professional section is not completed, the rental
loss will be disallowed.
The IRS released proposed Treasury Regulations in late 2011 that clearly
stated that if you hold your interest in property as a limited partner (if a
limited partnership) or as a member in a limited liability company (where
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someone else is the manager), then your loss is a passive loss. Period. Even
if you qualify as a real estate professional, the loss is a passive loss.
The solution is to do some management. This could mean having a general
partner position in addition to your limited partner if it’s a limited
partnership. In the case of a limited liability company, we recommend that
you become a manager-managed limited liability company and that you
are one of the managers. This will give you the potential, provided you
meet other criteria, of creating materially participating losses, which
allow you to offset other income.
Form 8582 (page 1)
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Form 8582 (page 2)
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Form 8582 (page 3)
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Documents the IRS Will Request
Partners’ Forms 1040.
Questions the IRS will Ask
None. The adjustment is computational, similar to the medical
adjustment.
Supporting Law the IRS Will Rely Upon
IRC section 469(i)(2) Up to $25,000 in rental real estate losses of an
individual may be deducted if the individual actively participates in the
activity.
IRC section 469(i)(3) The $25,000 offset is phased out at the rate of 50
cents for every dollar of MAGI in excess of $100,000.
Issue: Real Estate Rental Losses
IRS HANDBOOK POSITION
Rental real estate is a passive activity, unless the partner is a real estate
professional and materially participated in the rental activity. Issues on
real estate professionals are discussed in the next segment.
For partners who are not real estate professionals, no rental losses may
be deducted if the taxpayer’s MAGI exceeds $150,000. Furthermore, the
$25,000 offset is not available to either limited partners or partners
who own less than 10 percent of the partnership.
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US TAXAID ANALYSIS: Being a limited partner is a red flag for Real Estate
Professional status. If you’ve got one or more limited partnerships, NOW
might be a good time to re-examine how you are holding your properties.
We recommend using a manager-managed Limited Liability Company in
many circumstances.
IRS Examination Techniques
When examining a partnership return, verify that rental real estate
losses have not been improperly reflected on Schedules K and K-1 on
line 1 as trade or business losses. Rental real estate losses should be
reflected on K-1 line 2, as rental activities are generally passive, whether
or not the partner materially participated.
It is not uncommon for a partnership to conduct both a trade or
business activity and a rental activity. When examining the books and
records, be alert to items that are more properly allocated to the
partnership’s rental activities than to trade or business activities.
US TAXAID ANALYSIS: This is another common do-it- yourself error. When
you prepare a partnership return (and remember this could mean you
have a general partnership, a limited partnership or an LLC with multiple
members and default taxation), you can typically input your expenses as
“business” expenses or as “rental” expenses. If you have only rental income,
that means you have only rental expenses. There shouldn’t be expenses on
the business part of the return. (The IRS is looking for this because
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business deductions are FULLY deductible, whereas real estate deductions
are not.)
Rental income and losses are reflected for partnerships on Form 8825,
which is a schedule similar to Schedule E for Form 1040.
If the partnership conducts a rental real estate activity and losses are
properly reflected on Schedule K-1 line 2, scrutinize each partner’s
Form 1040 return for the following:
Is there an entry in box 43 of Schedule E indicating he/she is a real
estate professional? If so, losses will be deductible in the nonpassive
column, if he/she materially participated in the rental activity
conducted by the partnership. Material participation means the partner
performed more than 500 hours during the year on the rental or did
most of the work or met one of the other tests in Treas. Reg. section
1.469-5T. If the partner does not materially participate, Treas. Reg.
section 1.469- 9(e)(1) holds that losses remain passive. The losses
should be reported on Form 8582 line 1b or 3b. When considering
material participation, always check box 4 of the K-1 to see if the
taxpayer received a guaranteed payment. Most taxpayers do not work
without being compensated for their services!
US TAXAID ANALYSIS: If you have other partners in your LLC, and you are
claiming that you materially participated, it looks like the IRS is going to
want to see that you were paid something, and paid 15.3% self-
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employment tax on it. You may want to consider paying yourself
Guaranteed Payments (which are subject to self- employment tax) to
make sure you meet the requirement.
Form K-1 (Page 1)
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Form K-1 (Page 2)
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If the taxpayer is not a real estate professional (Schedule E line 43 is
blank):
Have partnership losses been entered in the nonpassive column of
Schedule in error? Rental real estate is a passive activity under IRC
section 469(c), whether or not the taxpayer materially participated.
Thus losses must be reported on Form 8582 line 1a, if the taxpayer
actively participated or line 3b, if not active (the taxpayer is a limited
partner or owns less than 10%, for example). Form 8582 limits total
rental losses to $25,000 and reduces the $25,000 special allowance to
zero, when modified AGI exceeds $150,000.
Have limited partners or those who own less than 10 percent of the
partnership entered losses on Form 8582 line 1b, thereby giving himself
the benefit of the $25,000 offset in error? Since a limited partner or
anyone who owns less than 10 percent cannot be active, losses reported
on line 3b. Losses on Form 8582 line 3b are deductible only if there is
passive income (which is relatively rare).
US TAXAID ANALYSIS: Translation - If you have your property in an LP
and you are acting ONLY as a limited partner, you’re not going to be able
to take advantage of flow-through losses.
US TAXAID ANALYSIS: A recent Court decision has said that a taxpayer
can combine general partner ownership and limited partner ownership as
qualifying material participation. HOWEVER, the ownership of both must
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be the same. You can’t combine an S Corporation and an LLC, for example.
Issue: Identification of Rental Real Estate Activities
IRS HANDBOOK
Peruse Blocks A, B and C of Form 1065 for indicators that the
partnership activity is rental real estate. Needless to say, if Form 8825 is
attached to the 1065, you are probably dealing with rental real estate. If
so, check Schedules K-1 for each partner to ascertain who is a limited
partner or who owns less the 10 percent.
There are a number of partnerships filed where the Business
Code/NAICS Code indicates the activity is a rental activity, yet losses are
reflected on K-1 line 1 as business losses. Needless to say, this warrants
careful scrutiny.
US TAXAID ANALYSIS: Make sure you have the right business code on your
tax return.
On the partners’ Forms 1040, scrutinize the nonpassive column on the
back of Schedule E for K-1 line 2 rental real estate losses which may
have been erroneously entered there. Rental real estate, if deductible,
generally should be entered on Form 8582 and in the passive loss
column on the back of Schedule E. Exception: rental real estate of a real
estate professional if the partner materially participated.
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Documents the IRS Will Request
Copies of each partner’s Form 1040.
Copy of any management agreement with an individual, agency or
tenant who might receive free or reduced rent for managing a rental
activity.
If there is both a business and a rental activity being conducted, ask for
a breakdown of expenses between the business and the rental. Questions the IRS Will Ask
If it is not clear from the return, ask if the partnership conducts a rental
real estate activity or an equipment leasing activity.
Ask what the level of involvement is for each partner. Active
participation is a liberal standard, requiring only management decisions
in a bona fide sense. However, as stated above, limited partners and
those with less than 10 percent ownership interest cannot be active. Supporting Law the IRS Will Rely Upon IRC section 469(c)(2) -- Rentals are passive activities. IRC section
469(a) and (d) -- Passive losses are deductible only to the extent of
passive income.
IRC section 469(c)(2) and (4) -- A rental (or leasing) activity if passive
whether or not the taxpayer materially participated. Exception: rental
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real estate of a estate professional (IRC section 469(c)(7)).
IRC section 469(c)(7) -- Rental real estate of a qualifying real estate
professional is excepted from the passive loss limitations if the taxpayer
materially participated in the rental. The taxpayer must rise to all the
following tests: (1) more than half his/her personal services must be in
real property business and rental real estate; (2) he/she must spend
more than 750 hours on real property businesses and real estate rentals
during the year; and (3) he/she must materially participate in each
separate real estate rental for losses to be fully deductible, i.e. treated as
nonpassive.
IRC section 469(i) -- Exception for rental real estate up to $25,000 if
MAGI is less than $100,000. Note no exception for any other kind of
rental.
IRC section 469(i)(3)(E) -- MAGI for Form 8582 line 6 is determined by
computing AGI without any passive loss (excess passive losses after
netting with passive income), any rental losses (whether or not allowed
by IRC section 469(c)(7)), Individual Retirement Plan (IRA)/Simplified
Employee Pension (SEP), taxable social security or one-half of selfemployment tax.
IRC section 469(i)(6)(A) -- The taxpayer is not active if his/her
ownership interest is less than 10 percent. Losses go on F8582 line 2b
(not line 1b); thus the taxpayer receives no $25,000 offset.
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IRC section 469(i)(6)(C) -- The taxpayer is not active if he/she is a
limited partner. Losses go on F8582 line 2b (not line 1b); thus the
taxpayer receives no $25,000 offset.
Issue: Material Participation Standard for Real Estate
Professionals
IRS HANDBOOK
If a partner spends the majority of his/her time on real property
businesses or rentals and more than 750 hours during the year, his/her
rental real estate activities are no longer automatically passive. Instead,
they are treated like a business. If the taxpayer materially participated
in the rental activity, losses are no longer subject to the passive loss
rules. Some taxpayers incorrectly assume if they work in a real property
business, rental losses are no longer subject to the passive loss
limitations.
Treas. Reg. section 1.469-9(e)(1) holds that a real estate professional’s
rental remains passive unless the taxpayer materially participated.
In the absence of a written election to group all rentals as a single
activity, each rental real estate property is a separate activity, in which
the partner must prove that he/she materially participated. If the
partner owns 50 percent or more of the partnership, each rental
conducted by the partnership is deemed a separate activity. Thus, the
partner must rise to material participation (work more than 500 hours
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during the year, perform most of the work or meet one of the other tests
in Treas. Reg. section 1.469-5T(a)) for each separate rental activity.
US TAXAID ANALYSIS: Yikes! Make sure you aggregate your properties. If
you can’t put your hands on the original election, do it again and keep it.
The IRS is now allowing you to make late aggregation elections.
A written election can be made to group rentals as a single activity,
making it easier to rise to the 500 hour test for material participation.
See Treas. Reg. section 1.469-9(g). The election can be made with any
original return and binds all future years. It is not retroactive. As a
practical matter, not many elections have been filed.
US TAXAID ANALYSIS: Did anyone else notice the last line? “... not many
elections have been filed.” The IRS knows most CPAs have not been
diligently doing this necessary step. They’re going to ask.
Update: The IRS has recently begun allowing taxpayers to make
aggregation election during the audit process. Still, don’t do this lightly
especially if there is pending sale with a loss.
Questions the IRS Will Ask
On review of the partnership return the IRS will ask you:
Who manages or oversees each rental activity.
If any partner(s) has specific duties in relation to any rental activity .
Where guaranteed payments were made (they’ll check the K-1s for
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IRS Examination Techniques On review of your Form 1040 the IRS will:
Check Schedule E line 43 to see if there is an entry indicting that the
taxpayer claimed to be a real estate professional.
Check the occupation beside each spouse’s name. Does one or the other
appear to be a real estate professional business?
Note whether the taxpayer and the spouse have full-time jobs and other
nonpassive activities. US TAXAID ANALYSIS: If you have entered something other than a real
estate activity as your occupation, look out!
Note where the Schedule E rentals are located in proximity to the
taxpayer’s residence. Ask who performs most of the work on the rentals,
husband or wife. Inquire what partner services the Taxpayer performs
with his/her rentals. Because partnerships are not required to take passive losses or credits
into account for their taxable year, the passive loss limitation generally
is not a partnership item for TEFRA entities. (TEFRA means the Tax
Equity and Fiscal Responsibility Act of 1982.) A TEFRA partnership is
generally one with 11 or more partners, or, where there are less than 11
partners, any of those partners are non-resident aliens, LLCs, trusts,
other Partnerships or S Corporations).
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If an individual partner’s return is open and the issue is solely meeting
the hourly tests for material participation in Treas. Reg. section 1.4695T(a), there is no need to open the Form 1065. The resolution of the
issue of whether a partner is subject to the passive loss limitation is not
a partnership item. Whether the passive loss limitations apply to a
partner has no effect on any item on the partnership's books and
records. Material participation is based solely on hours worked by the
individual investor .
For an open TEFRA partnership, the issue of material participation by
partners should be treated as an affected item.
If there is an issue as to the characterization of loss or income, i.e.
whether the partnership is conducting a trade or business, or whether it
is engaged in a rental activity, or whether income should be
characterized as portfolio income, the partnership entity must be
opened. That is an entity level determination.
Issue: Identification of Non-Material Participation
Factors
IRS HANDBOOK
Scrutinize each rental property on Form 8825 and on Schedule E. The
following are indictors that the partner does not materially participate:
Commissions;
Management fees;
Large labor or wages;
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Rental property is located a long distance from the partner’s
residence;
The taxpayer is a limited partner;
The taxpayer has a low ownership interest in the partnership. USTAXAID ANALYSIS: If you have commissions, management fees or labor
costs, you’re going to have to prove that you materially participated. Any
kind of additional evidence would be good here. Do you have a picture of
you working at the property? Maybe a Home Depot invoice? Proof you
have experience doing maintenance or construction? Unfortunately if you
have less than 10% ownership or are a limited partner, you probably
aren’t going to win this argument. Documents the IRS Will Request
Partner’s Form 1040.
Copy of the return with an election the partner may have made to group
rentals as a single activity under IRC section 469(c)(7)(A) and Treas.
Reg. section 1.469-9(g) and the return with which it was made. While
many taxpayers have not grouped, those that did, often made the
election with their 1995 Form 1040.
If the partnership grouped its rentals under the provisions of Treas. Reg.
section 1.469-4(d)(5), a copy of the tax workpapers or any other
documentation indicating rentals were grouped.
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If the taxpayer is a real estate professional and treated rental real estate
losses as nonpassive, services performed on each rental activity and
hours attributable to those services. Questions the IRS Will Ask You
Who monitors the rental? Who collects the rent? Who does the repairs?
Does the partnership pay anyone to manage or oversee the rental,
handle rental income, deal with problems, etc.?
Do you have a real estate agent or manager?
Does a relative or friend manage/monitor the property for free? Does a tenant receive free/reduced rent for managing the rentals, or for
caring for the properties? This is common practice with large apartment
buildings.
US TAXAID ANALYSIS: The examiner will ask you about this for each
rental property, and will check your Form 8825 properties for
commissions, management fees or other supervisory expense. He or she
will also check for large labor expense; possibly a hired contractor that
spent more time on-site than you did. If the examiner finds that there is
paid management, he or she will treat it as a strong indicator that you
did not materially participate. Because this is a critical question to the
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Real Estate Professional determination, you can expect to be asked
about on-site management several times, and in several different ways.
Supporting Law the IRS Will Rely Upon
IRC section 469(c)(7) -- Real estate losses are nonpassive if the taxpayer
spends more than half his/ her services and more than 750 hours on
real property businesses and materially participates in his/her rentals.
IRC section 469(c)(7)(A)(ii) and Treas. Reg. section 1.469-9(e)(3) -Each rental is a separate activity unless taxpayer elected to group under
Treas. Reg. section 1.469-9(g) (not seen often). Thus, even if taxpayer is
a real estate professional, he/she still must meet material participation
(Treas. Reg. section 1.469-5T(a)) for each separate rental before losses
will be fully deductible.
Treas. Reg. section 1.469-9(e) – Even if the taxpayer is a real estate
professional, he/she must still materially participate in each separate
rental before losses are nonpassive. If the taxpayer does not materially
participate, losses remain passive.
Treas. Reg. section 1.469-9(g) -- The taxpayer must file a written
election with an original return to group all rentals as a single activity.
Treas. Reg. section 1.469-9(h)(2) -- Each rental in a partnership is a
single interest in rental real estate if taxpayer owns 50 percent or more
of the entity. The taxpayer may elect to treat all rental real estate
interests as a single activity.
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Treas. Reg. section 1.469-5T(a) -- Tests to be applied to determine
whether the taxpayer materially participates, that is, whether losses are
deductible.
Issue: Identification of Non-Qualifying Passive Activities
IRS HANDBOOK
In order to deduct losses from a partnership that conducts a trade or
business, the partner must prove that he/she works on a regular,
continuous and substantial basis in the operations of the activity. Treas.
Reg. section 1.469-5T(a) holds that an individual taxpayer materially
participates if and only if he/she meets one of seven tests for material
participation, the most common of which is the 500-hour test.
The following hours are not counted in the hourly computations for
material participation: investor-type activities (reading reports,
monitoring as a nonmanager, etc.) and work not customarily done by an
owner if the purpose is to avoid the passive loss limitations. Treas. Reg.
section 1.469-5T(f)(2).
US TAXAID ANALYSIS: This last paragraph concerns me. It sounds like a
judgment call that is going to end up in court. When are you an investor
and when are you active? And then the ultimate is “You just did this to
avoid the passive loss limitations.” It will be hard to prove intent, I suspect.
The best advice might be to make sure you have way more than 750 hours
documented.
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Examination Techniques the IRS Will Use
At the initial interview, ask what services each partner performs for the
partnership. Inquire how often each partner is at the partnership’s
business location.
Look for guaranteed payments as an indicator that the partner does
work on a regular basis in the partnership. Most taxpayers do not work
without compensation.
Note which partners are limited partners or have a smaller ownership
interest.
When perusing the partners’ Forms 1040, look for losses in the
nonpassive column. If losses are entered in the nonpassive column, the
taxpayer is indicating that he/she materially participated in the activity,
that is meeting one of seven tests in Treas. Reg. section 1.469-5T(a). The following items on a partner’s Schedule K-1 are possible indicators
that he/she does not materially participate in the partnership’s
business:
o Limited partnership interest;
o Low ownership interest;
o Partnership is a significant distance from the partner’s residence;
o No guaranteed payment on Schedule K-1 line 4.
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Documents the IRS Will Request From You
From partners who do not appear to work regularly in the partnership,
ask them to document services performed and hours attributable to
those services for the year under examination.
Ask if the partnership activity has been grouped with a related business
under the “activity” rules in Treas. Reg. section 1.469-4.
Request the partnership agreement with portions highlighted that
address who manages the entity or any other item that may address the
partners’ participation.
US TAXAID ANALYSIS: Not having a final, signed Operating Agreement or
Partnership Agreement could be a problem here. Many people,
unfortunately, take more of a do-it- yourself approach to forming an
entity and never take the time to prepare or finalize the Operating
Agreement. This is a mistake, especially if the IRS comes calling. Make sure
you have an agreement and that it outlines responsibilities that will help
support that you are active in respect to the company.
Questions the IRS Will Ask You
What services does each partner perform?
Approximately how many hours did each partner work?
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What records does the partner have to substantiate hours worked?
Is each partner directly involved in day-to-day management?
Is there an on-site manager/supervisor/foreman?
Which partners have signatory authority on checks?
Which partners have authority to borrow money? Hire/fire personnel?
Is work being performed by the partner required or necessary for the
activity?
Is the partner compensated for participation? If not, why?
US TAXAID ANALYSIS: The questions in this section focus more on the
authority that you have in the partnership. These are important points
that should be included in the annual minutes. Supporting Law the IRS Will Rely Upon
IRC section 469(c)(1) -- Passive activity is a business in which the
taxpayer does not materially participate.
IRC section 469(h) -- A taxpayer materially participates only if he/she is
involved in the operations of an activity on a regular, continuous, and
substantial basis.
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Treas. Reg. section 1.469-5T(a) -- Taxpayer materially participates if
and only if he/she meets one of 7 tests. Most common: Does he/she
work 500 hours in the activity in the year under exam?
Treas. Reg. section 1.469-5T(f)(4) -- Reasonable means for proving
hours requires (1) an identification of services provided and (2) hours
spent performing those services during the year based on appointment
books, calendars, narrative summaries.
Conclusion
If you are a real estate professional, and you are under pressure from
the IRS, it is possible to win your argument. But to win, you’ve got be
prepared in the first place. You need to have a firm understanding of the
guidelines. You’ve got to have documentary and other proof that you
have followed the rules.
And, finally, consider getting help. This is one of those times where
having your CPA or EA represent you can make the difference between
keeping your tax deduction and losing it. As with all of our Audit
Survival material, we recommend that you never try to do this alone or
without expert guidance.
We offer twice monthly coaching on real estate and business at
USTaxAid.com. Come see how we can help you keep more money.
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Disclaimer Information Only – Not Legal Advice
This publication is designed to provide general information regarding the subject
matter covered. It is not intended to serve as legal, tax, or other financial advice
related to individual situations. Because each individual’s legal, tax, and financial
situation is different, specific advice should be tailored to the particular
circumstances. For this reason, you are advised to consult with your own attorney,
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was written. However, we will assume no responsibility for any errors or omissions.
We specifically disclaim any liability resulting from the use or application of the
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To ensure compliance with requirements imposed by the IRS, we inform you that
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