Safely Taking the Real Estate Professional
Status
By Diane Kennedy, CPA
Let’s start with who should read this Home Study Course.
This is vital information for you if you have:
Income over $100,000 and plan to build a passive real estate portfolio,
or
Income under $100,000 and you want to eliminate taxes.
There is a lot you can do with the real estate professional tax
loophole. First, though, let’s start off with how some people get this
special tax loophole wrong.
Seminar Attendees Get Wrong Information and It Costs Them
Big-Time
I first met this couple after they’d just lost a big IRS audit and they
had no idea what had gone wrong. They owed $20,000 and they
didn’t have it.
We handle a lot of IRS and state tax representation work. I wish we
had been in on this audit from the beginning. It’s always harder and
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more expensive to win an audit, or at least contain it, when we come
in later. That was mistake #1. They made that first phone call
themselves, without a strategy first. And that means they just kind of
spilled their guts, increasing the time and scope of the audit.
YIKES! You can control everything with that call, but you have to
know 3 key things first:
(1)
Which audit technique guide (ATG) the auditor is using,
(2)
Which entity(ies) is the auditor targeting now, and
(3)
What was the triggering event.
All the clues are in the first letter you receive announcing that your
return has been selected for audit.
There is more information on what you MUST do if you get that
dreaded letter in the “Winning an IRS Audit” section at the end of
this home study course.
Meanwhile, though, for my prospective clients we had lost the option
of using any audit strategy. At this point, all we could do is fight it
head on, if there was a case they could win.
All we could do now is look at the facts of the case.
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They were a married couple with a combined income of about
$230,000. Both worked full-time jobs and didn’t have a side or parttime business. They had 5 real estate properties that create actual
cash flow losses each year. In other words, the cash was flowing all
right…away from them.
They self-prepared their return and they just added in the default
depreciation. That gave them approximately $40,000 in real estate tax
losses.
This is where it got dicey. They used TurboTax. I’m not going to go
on a rant against TurboTax because the fact is that it works great, in
the right circumstances. If you’ve got a simple return with a job or
two and maybe even some itemized deductions, you’re fine with
Turbo Tax. But, if you’re planning to be strategic with a business or
real estate, you better know the current tax law.
They noticed that there was a box in the program that they could
check that said they were real estate professionals. There was no
additional information available and they had no idea what that
really meant, but they noticed the amount of tax they owed went way
down if they checked it.
TurboTax was awesome, they decided.
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They checked the box. Sent in the return and now the mean old IRS
was after them.
They tried to handle the audit themselves and now they had a
$20,000 bill.
You’re up to date.
There wasn’t much we could do at this point except whittle away at
some of the more onerous penalties that suggested they had
committed fraud with the return.
They hadn’t. But I also knew if we tried to fight this too hard, the IRS
was going to bring up Tax Court Mem. 2011-69 where the Court
threw the book at a couple who tried to blame TurboTax for allowing
them to take a deduction they shouldn’t have been able to take.
The problem was that they weren’t real estate professionals. The
problem was that they had checked a box without having a clue what
it meant. Or, had they checked a box knowing full well they didn’t
qualify? If so, that’s fraud.
In the end, we got the IRS to agree to a payment plan and $15,000
instead of the original $20,000 in tax due.
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Real estate professional status is a great way to pay less tax, but you
have to be a legitimate real estate professional to take it.
Why Does the Real Estate Professional Status Matter?
If your adjusted gross income (AGI) is under $100,000, you can take a
deduction of up to $25,000 of real estate losses against your other
income, provided you have active participation.
If your AGI is over $150,000, you can’t take any deduction of real
estate losses unless you are a real estate professional.
If your adjusted gross income is between $100,000 and $150,000, the
amount you can deduct phases out.
If you are a real estate professional, you can take an unlimited
amount of real estate losses as a deduction, no matter how much
money you make and no matter how much the loss is.
If you’re married and filing jointly, either you or your spouse can be
a real estate professional and get the same great tax break on your
joint tax return.
Do I qualify as a real estate professional? Quick Answer:
The Three Tests of Real Estate Professional Status
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There are three tests you (or your spouse) need to pass to qualify as a
real estate professional:
#1: You must have 750 hours of real estate activity and more hours in
real estate activities than any other trade or business,
#2: You must materially participate in the property, and
#3: Each property must individually qualify for material
participation.
The definition may seem pretty straightforward, but the way it’s
applied is anything but simple. We’ll cover more definitions and
strategies to apply them throughout the rest of the home study
course.
Is Your Real Estate Really a Business?
In March 2015, I put on a high-level real estate summit for
sophisticated real estate investors. It was for experienced investors
only and we talked about leverage, asset protection and tax
strategies, of course, but we also exchanged rolodexes. That was
probably the most valuable part of the event!
A couple attended the event who were trying to figure out how to
take deductions for a couple of their very high-end fix-n-flip
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properties ($10 million+ price tag). They already had cash buyers for
the two properties, but they weren’t going to close until the next year
and they wanted to take some deductions in 2015.
What could they do?
As we talked about the properties and the unique market, we talked
about the fact that these could be very high-level vacation rentals for
a season. They had furnishings already and they didn’t expect much
wear and tear from some high-end renters. And if they did get
trashed, they made sure the renters could afford the bill.
The biggest benefit, though, wasn’t the fact that they’d pick up some
cash from the rent. The benefit was that they’d get some good
deductions.
Normally, if a client told me they had a bunch of deductions and
were renting out their house to take advantage of them, my next
questions would if and how they could take a deduction for the tax
loss.
It didn’t matter in this case.
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That’s because they had a real estate business and therefore, an active
loss. It wasn’t a real estate passive loss, subject to limitations based on
income.
It was defined as a business because the property was rented out for
short term stays (average of one week or less) and substantial
services were provided. In their case that means maid service was
provided. If they had been long-term rentals, then the losses would
have been passive. That’s an important distinction.
A vacation home rental, just like a hotel or motel, is usually
considered a business, instead of passive investment. The two key
definition differences are: short stay (defined as average one week or
less) and substantial services such as housekeeping are provided.
If you have a net loss with a business, you need to prove you have
basis to take the deduction. In other words, you have recourse debt
or, if it’s a business held in an entity, prove you have loaned
sufficient money to the business or purchased equity. Other than that
requirement, it’s pretty easy to take a business loss.
Just Cause You Call it a Business, Doesn’t Mean It’s a Business
Business losses are usually deductible. A passive real estate loss is
much more complicated.
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There are a couple of strategies that taxpayers have tried to take
advantage of that fact. Here are two that won’t work:
Mistake #1: Use a business structure and call it something else.
If you form an S Corporation, partnership or multi-member LLC and
hold your property inside that, any passive loss you have will still be
a passive loss.
That’s true even if you combine the real estate with a regular business
you already have. The passive income/loss is reported separately
from the business income/loss. You can’t combine them unless the
real estate is used for the business.
In other words, a business structure can’t change the character of the
income. If it’s passive, it’s passive. And that means a passive loss that
flows through a business structure is still a passive loss when it hits
your tax return.
The one exception is if you have a C Corporation hold your property.
In that case, the C Corporation doesn’t have the same passive loss
restrictions. However, there are other reasons why you probably
shouldn’t have a C Corporation hold your property. Appreciating
property will end up having a lot more tax when it sells if it’s held
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inside a C Corp. Even though you might get a write-off, you’ll end up
paying a whole lot more tax in the end.
To sum it up, you can’t run a real estate passive loss through a flowthrough entity like an S Corporation, LLC or partnership and expect
it to be different.
Mistake #2: Setting up a “property management” company for your
own property.
In this illegal tax scheme, the taxpayer sets up a business for property
management. On the face of that, it’s completely legal. You can set up
a property management business and it’s taxed just like any other
business…provided you have clients.
If the only client you have is yourself, then all you’ve done is try to
move expenses off your Schedule E (rental property reporting) where
the loss would be a passive loss.
You can’t change the character of your passive losses by using
another schedule or form.
Doctor Uses Real Estate Professional Status to Build Assets
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I have a client who is a highly compensated Dr. His wife works part
time as a nurse. They want to build up a real estate business to
eventually replace his income.
But meanwhile, because of his high income they don’t get many tax
breaks. That’s when they came to me for a consultation. Is there a
way they could build real estate and be able to get tax advantages?
The answer is “YES!”
The Dr. couldn’t qualify as a real estate professional because of the
first part of the 3 part test. He would need to have 750 hours a year of
real estate activities and more time in real estate activities than any
other trade or business. He worked a lot of hours as a Dr. and it was
just not physically possible for him to work more hours as a real
estate professional.
However, his wife was happy to take on that role. She quit her parttime job as a nurse and devoted her time to their growing real estate
portfolio.
They bought undervalued apartment houses remodeled them using
her talent at working with architects and engineers to create better
use of the space. She was out at the job site every day, checking on
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the progress, and then worked with the onsite manager to get the
units rented to the best possible tenants.
And the additional good news was that we were able to do a cost
segregation study to front end load the depreciation. This created a
tax loss (while they were still collecting rental income) that offset his
high salary and dramatically cut their taxes.
More deductions = less tax. Less tax = more cash to invest with. More
investments = more deductions and a greater rate of investment
growth.
Within 7 years, they had built a massive, cash flowing real estate
portfolio. The net cash flow from the real estate was more than the
Dr. used to bring home, after all the taxes he had to pay.
Now, the family had choices. And that is true freedom.
The Three Unique Benefits of Real Estate
Real estate is the only investment that will give you:
(1)
Cash flow,
(2)
Appreciation, and
(3)
Tax breaks.
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Not every real estate property is going to give you both cash flow
and appreciation. Of the two, cash flow is what will keep you out of
trouble. Otherwise, if you’re buying a property strictly for
appreciation you’re making a bet that the economy will continue to
grow and that there will be someone who can afford the property
and wants to buy it for more than you did. It’s called the “bigger
fool” strategy.
A better and safer strategy is to buy for cash flow.
Here’s Who Made Money When Real Estate Crashed
For decades, real estate was considered the investment that couldn’t
lose. After all, real estate is the one asset that they’re not making
anymore of, right?
Maybe, but it’s also possible to way overbuild beyond what demand
calls for. That, coupled with ridiculous loans and investments based
solely on the speculation that appreciation was inevitable, caused the
downturn. Want to know more about what went wrong in the
housing market? There are some great movies out like “Margin Call”
and “The Big Short” that explain some of the highlights in easy bullet
points.
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If you buy instead for cash flow, paying attention to the rental pools
and long term prediction for more renters for properties like yours,
you’ll be in a much more secure position.
There were people who made a lot of money in the real estate
downturn and, no, they’re not just the guys who shorted the market.
They are the ones who had cash flowing assets no matter what the
market said the value was. And then, when property values dropped
below any sense of reasonableness, they bought more.
I have clients who bought houses for $30,000 that cost over $100,000
to build and now sell for $200,000.
Buy for cash flow, not appreciation.
Strategies to Utilize Real Estate Paper Losses
As a real estate investor, you may already know that one of the
biggest tax benefits from real estate is your ability to offset your other
income with paper losses (primarily caused by depreciation).
If you (or your spouse, if you’re married) can qualify as a real estate
professional with material participation you can use 100% of your
paper real estate losses to offset your other income. If you can’t
qualify your offset is limited to $25,000, as long as your income is
under $100,000 and you have active participation. Once your income
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exceeds $100,000 that deduction begins to decrease as your income
rises.
By the time your income hits $150,000, the $25,000 deduction is gone
altogether. But that doesn’t mean your paper losses go away. They
are simply suspended.
When you eventually sell the property, you’ll be able to deduct all
the suspended losses from your sale proceeds unless you have made
an aggregation election. It is also possible to take advantage of
suspended losses without selling your property if your status
changes and/or your income drops below $100,000.
You’ve got to meet certain tests to qualify as a REP, or real estate
professional. First, your status is based on hours that are performed
in real estate functions. There’s a minimum of 750 hours per year to
qualify. If you do other things besides real estate, you’ve got to hit
this 750-hour threshold, PLUS you must spend more time in real
estate activities than in any other paid activity to qualify. That’s why
it’s very difficult for people who work full-time to earn REP status.
The IRS doesn’t think it’s reasonable for someone with a full-time 40+
hour/week career job to also spend more time in real estate activities.
You can also qualify as a REP if you own more than 5% of a real
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estate related business. If you’re a real estate agent, you are probably
being paid via 1099. That means you qualify. You don’t need to own
part of the real estate agency. But if you are paid a salary and receive
a W-2, then you do need to own 5% or more of the agency to qualify.
Even with these strategies, you will still need to meet the minimum
750-hour threshold requirement.
There are two additional items to consider. These are what qualifying
real estate activities actually are and how to qualify for material
participation in each property.
First, let’s look at what qualified real estate activities actually are.
This has been an area under heavy attack by the IRS in recent years.
What Are Real Estate Activities?
A qualified real estate activity is any activity in which you “develop,
redevelop, construct, reconstruct, acquire, convert, rent, operate,
manage, lease or sell” real estate. That doesn’t mean you need to be
physically doing construction work, etc. The key is that you perform
personal services in these activities. So you could be supervising,
meeting, planning, and so on.
 Develop: Meeting with engineers, architects, planners,
equipment operators, construction personnel, drafters, financial
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professionals, accounting and legal professionals, etc., to
discuss and implement development of property. You could be
performing some of the development or it could be time you
spend hiring, supervising and reviewing the work of other
professionals. The development could be anything from
subdividing property, with no additional amenities added, to
actual construction of real property.
 Redevelop: Meeting with engineers, architects, planners,
equipment operators, construction personnel, drafters, financial
professionals, accounting and legal professionals, etc., to
discuss and implement demolition of structures and/or
redevelopment of the property. Again, you could be
performing some of the physical work or it could be time you
spend hiring, supervising and reviewing the work of other
professionals.
 Construct: The time spent in meetings, planning, hiring, firing,
supervision, or inspection of any phase of construction
qualifies.
 Reconstruct: As with Construct, qualified activities under
“reconstruct” are any ones that are necessary to this phase of
building.
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 Acquire: Acquiring a property has many phases – meeting with
sales people, looking at real estate, preparing an offer,
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. Don’t forget to count the time you spend traveling
back and forth to the property.
 Convert: Conversion of property is similar to redevelopment or
reconstruction, but might have the additional time element of
meeting with government planning officials. All of that time
counts toward time spent in qualified real estate activities.
 Rent: The time you spend 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. The IRS has been
challenging ‘arm chair management’. They want to see that you
physically are involved in this process.
 Operate: 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.
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 Manage: 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.
 Lease: The time spent meeting with your property managers to
establish leasing criteria, as well as acting as rental agent
yourself (including the showing, screening, advertising, etc.),
will count as qualified real estate time.
 Sell: 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.
If you think you’re a qualified real estate professional and you’re not
doing one of these activities, then you probably are NOT a qualified
real estate professional. This is the exclusive list that the IRS has
provided showing what will qualify for the required 750+ hours of
real estate activity. Remember this activity must be more than in any
other trade or business to pass the test.
Audit Red Flags with Real Estate Professional Status
There are still two more tests beyond the 750+ hour and more hours
than any other business or trade test, but it’s probably a good time to
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just take a second and go through the things you might put on your
tax return that could cause a problem.
We call these audit red flags. In other words, they could flag your tax
return for audit.
Audit red flag #1: You have another job with high income.
Of course, having another job doesn’t necessarily mean you don’t
have real estate professional status, but it does mean that the IRS may
think you claimed it just for the tax breaks.
If you have another business, you may need to prove how many
hours you worked in it so that you can prove you’ve got more real
estate activity time than time in the business.
Keep a journal!
Audit red flag #2: Reporting your occupation as something other
than real estate.
You need to write down your occupation next your signature on
page 2 of your Form 1040. If you’re going to also claim you’re a real
estate professional, make sure you disclose a real estate-centric
occupation.
Audit red flag #3: Owning out of state properties.
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In this case, the IRS might question how you could materially
participate in running these properties. You could pass the first test
of hours in real estate activity, but can you also pass the second test
of material participation?
Audit red flag #4: Owning a timeshare.
There is no great strategy here. The IRS, by definition, says it’s
impossible to materially participate in running a timeshare. You can’t
take a timeshare loss against other income.
However, you could have your separate business pay a reasonable
rent for use of the timeshare. A few of my clients pay that rent and
then do a bonus for employee of the year, best vendor and - although
I keep suggesting it, no one has done it yet – favorite CPA.
If your company pays a fair market rent, it’s an expense for the
business and income for you, but you can use timeshare costs to
offset the income. The timeshare costs can’t create a deductible loss,
but they can offset timeshare income.
Audit red flag #5: Being a limited partner.
There are a number of different entities you may use to hold real
estate. Usually I recommend an LLC (limited liability company) with
default taxation. And since 2010, the IRS has strongly suggested that
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you make the LLC manager-managed with you and/or your spouse
as a manager to further prove you are involved.
Audit red flag #6: Using a trust.
There is really no such thing as a bad trust, just a misused and
misunderstood trust.
A trust is not the ultimate “never pay tax” device. In fact, you’ll often
pay more in tax with a trust than a regular LLC.
A trust is not the ultimate in privacy. In fact, it’s pretty much equal to
an LLC in that regard.
A trust is not a way to get around a law you don’t like. In fact, if you
tried to hide an illegal activity with a trust, you would be committing
fraud.
A trust is a great estate-planning tool. A foreign trust is integral to a
legitimate offshore strategy. There are legitimate, legal and smart
reasons to have a trust.
However, there are so many bad trust schemes that the IRS considers
any trust to be a red flag.
Taxpayer Changes LLC to Win Audit
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A taxpayer received an IRS notice. Fortunately, he knew what the
triggering event was.
He had set up a limited partnership to hold an apartment house.
Limited partnerships have two types of partners: general partners
and limited partners. The general partner has responsibility for
running the partnership and also has full liability. That’s why most
people will use a LLC or corporation to hold the general partnership
position. A limited partner doesn’t have anything to do with running
the company (at least they’re not supposed to) and the only risk they
have is the amount of money that they’ve put into the deal. There is
no other risk for the limited partner.
He used a limited partnership because he planned to transfer the
asset to his kids. So, he gifted some of the partnership units every
year. He held a majority limited partnership interest and the general
partnership was a corporation that was owned by someone else. He
did that so he didn’t run into controlled group issues with another
corporation he owned.
The rental property had a loss because they maximized the
depreciation.
So far, so good, except for one big problem. He took the loss on his
tax return.
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He didn’t own the corporation, so his only interest was a limited
partnership interest. And remember, the limited partner can’t
participate in management decisions. By definition, he wasn’t
materially participating.
The IRS has been focusing on limited partnerships that hold real
estate, trying to catch taxpayers on this very issue.
He knew he had a possible problem and so formed a managermanaged LLC to hold the property. He rolled over interests from the
partnership and named himself as a manager. The corporation
general partnership wasn’t required anymore for asset protection, but
he kept the corporation with the same percentage of ownership so
there was no tax consequence for the change.
The IRS could have audited him and denied the loss for the years that
he owned the LP, but he figured that he’d show them that he had
changed the structure to stop a problem.
Technically, he had a problem, but he could demonstrate that he’d
already taken steps to correct it.
With a little luck and strategic conversations, he won the argument
and kept his deductions.
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Material Participation
The second test for the real estate professional status is the material
participation test. In addition to having real estate activities in
general, you’ve also got to have material participation with the
property.
There are three different ways to prove material participation.
(1)
You spend 500 hours or more in material participation with
the property,
(2)
You spend 100 hours or more and more than any other one
person in material participation with the property, or
(3)
You spend more hours than all other involved people
combined in material participation with the property.
There isn’t a clear-cut definition of what it means to have material
participation, but by reading the regulations it generally means to
simply be in the business of real estate with respect to the property.
The times when the IRS challenges hours typically has been when the
work done is more passive. For example, the taxpayer just reviewed
websites or checked in remotely. He or she never directly worked
with the property, property contractors or tenants. That type or hours
won’t count.
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You can use the hours with the property to qualify for the first test
(750 hours and more than any other business), but they don’t have to
be the same activities for each. In other words, you could have real
estate activities that qualify for test #1 and material participation
hours for the property that qualify for test #2.
And there is one more distinction: While you or your spouse must
individually meet the hour requirements of test #1, you can combine
hours with your spouse to meet test #2.
Although the tax code doesn’t say this anywhere, the IRS has taken
the position that if you have a property manager, you can only use
the 500-hour test to qualify. Until someone challenges the IRS stance
in Tax Court, plan to meet that test for your property(ies).
AGI Less Than $100K? You’re Still Not Out of the Woods
It bears mentioning that there is also a lower standard of active
participation that is available in some cases. This second standard has
confused both taxpayers and tax preparers alike.
The active participation rules require just 100 hours per year. This is
the standard that is used if the real estate is an active trade or
business and/or you make less than $100,000 per year. In the case of
the active trade or business, the IRS is looking for you prove that
your real estate is a business, not an investment. So, it means that you
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are involved in flipping properties, are a real estate dealer or the
rentals themselves are businesses, than you have met the active
participation requirement.
There is one more time that it may apply.
If your adjusted gross income is under $100,000 per year, you still
need to prove active participation to take advantage of the up-to$25,000 passive loss deduction. That means you need to prove real
estate activity of at least 100 hours per year and your interest can not
be held solely as a limited partner in a limited partnership or as a
member only inside a limited liability company.
IRS Challenges to Real Estate Professional Status
Taxpayers claiming real estate professional status are IRS audit
targets.
During the boom years of real estate, many investors found
themselves with a declining rental pool and skyrocketing purchase
prices.
That meant ongoing monthly losses on their real estate properties,
before depreciation was even taken. That led many people to ‘stretch
the truth’ a little when it came to claiming REP status. Having REP
status let them take the losses and they figured the IRS wouldn’t be
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checking.
Unfortunately, the IRS did check and found enough people who had
improperly taken the deduction to determine that it was now worth
the time to mount an audit campaign targeting real estate
professionals.
The challenges appear to come in a number of ways:
1. Invalid material participation due to wrong entity set-up.
The IRS is looking to make sure that the property is held in the
proper entity and that the entity’s agreements are written properly.
Being a limited partner in a Limited Partnership won’t work, and
even being a passive Member in an LLC might not work if the
Operating Agreement isn’t written in a specific manner. The better
business structure is a manager-managed LLC when you (or your
spouse) is listed as a manager.
2. Invalid material participation due to missing aggregation election.
The third test is that each property must stand on its own for the
material participation test, unless you make an aggregation election.
The aggregation election is made on your return. You can make the
election late and in fact, you can even make it if you’re in the middle
of an audit. We’re going to talk next about pros and cons of
aggregation. Right now, know that you may have an issue later if
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you’re audited but that there is a very easy fix.
3. Invalid material participation due to ‘inactive’ activities.
You can’t count the time you spend researching real estate, or
Internet surfing as activity. You need to actually be active and
working on or in the properties.
4. Undocumented REP hours.
It’s important to keep some kind of journal and track your time to
clearly show at least 750 hours per year of real estate activities.
Other tracking methods can help here, too. For example, take pictures
of yourself at your properties, or at meetings with construction
workers, property managers, etc.
5. Real estate professional hours not active.
Make sure your real estate activity hours count for qualified real
estate activities. This is similar to the inactive material participation
activity issues.
6. Real estate professional hours exceeded by other activities.
Remember, it isn’t just 750 hours period. If you have another incomeproducing business or job, you must spend more time doing your
real estate professional activities than activities in any other trade or
business.
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The IRS also tries to attack some of the real estate activities claimed
by real estate professionals. For example, initially the IRS took the
position that a real estate agent could not broker a deal if he or she
wasn’t also a licensed broker. Time spent as a real estate agent didn’t
count, they said.
Fortunately, the Tax Court shot this IRS argument down, and the IRS
has now conceded that a real estate agent is truly a real estate
professional.
What Does it Take to be a Real Estate Professional?
There are three tests:
#1: You or your spouse if you file jointly, must individually qualify
with 750+ hours per year of real estate activities and more real estate
activities than activities in any other trade or business,
#2: You must have material participation in the property (you can
combine your hours with a spouse in this case), and
#3: Each property must individually qualify.
Individually Qualify or Aggregate a Group?
The third test is that each property must individually qualify.
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That means if you have property managers for 10 properties you own
and rent, you would need to have at least 500 hours PER PROPERTY,
for a total of 5,000 hours.
That’s probably impossible, especially if you have properties with
long-term tenants. There simply isn’t that much time required to
manage the properties.
The IRS gives you another option.
You can make an aggregation election. That is an election that you
make with your return that lists out the properties you want included
in a group. You then treat the group like one property for material
participation. In other words, instead of your 10 properties needing
5,000 hours of material participation, they’d only need 500 in total to
qualify.
If you buy additional property and want to add it to your group, you
will need to make an additional election later on.
There is a downside to aggregation, however. Once you’ve put the
group together, they stay together. The losses stay in the group as
well.
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Let’s say one of your aggregated properties has a $20,000 loss when
you sell it. Normally, that loss could offset your other income. That
changes when you aggregate a group of properties. In that case, the
loss stays in the group and has to be used to offset future gains.
You’ll have to wait until all the properties in the group are sold,
before you can finally take the loss against other income.
It is possible to de-aggregate a group but you need to proactively
make that election change and show that the circumstances have
changed. You’ll also have to make that change before you sell the
property with the loss.
Winning an IRS Audit as a Real Estate Professional
An IRS or state audit starts with a letter. Open it up and there will be
a list of things that the auditor is asking about, a lot of pages about
your rights and some pretty scary pages about penalties you might
be subject to and then there is a phone number and name. Call
anytime! But call, the letter says, fast, or you could be in a lot of
trouble.
Don’t ignore the letter. But don’t panic either. This is the time for
strategy. If you’re a real estate investor who had a loss, and especially
if you took the real estate professional status on a past return, you
definitely need to take a deep breath before you do anything.
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Don’t ignore the letter. That’s the probably the worst thing you could
do. But don’t pick up the phone and make a call either. That’s the
second worst thing you could do. You need a little more information
before you talk to the IRS.
First of all, let’s look at why the IRS is after you.
Do You Have a Target On Your Back?
The IRS audits people because they are looking for more tax money.
Real estate is an investment that lets you create cash flow and grow
wealth with very little, if any, taxes. So, it’s pretty obvious that the
IRS is going to be looking at real estate investors to make sure there
isn’t some extra tax due. But some of us are more likely to be audited
than others.
Do you have a target on your back? Perhaps. If you’re a real estate
investor who has ever taken a real estate loss on your tax return, the
IRS might be paying attention. This is especially true if you took
advantage of the Real Estate Professional (REP) designation.
The IRS started getting tough on taxpayers who took real estate
losses back in 2007, right when the real estate market started to tank
in many areas. It’s not really surprising that the timing worked out
the way it did because typically IRS audits will run 1 1⁄2 - 2 years
after a return is filed. If you count back from 2007, you’ll be right in
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the heat of the real estate craziness. People bought properties right
and left, often because if they waited, they knew the price was going
up. Plus, loans were easy to get; so why not buy? But the purchases
didn’t make financial sense. The escalating market had pushed prices
up and rents down because anyone could qualify for a home loan.
That meant a lot of people had negative cash flow and they wanted to
write off the losses.
That’s exactly what the IRS was looking at. People were trying all
kinds of things, some not exactly legal, to take those as write-offs on
their tax returns.
If you make under $100,000 a year (adjusted gross income), you can
take up to $25,000 of real estate losses against your other income. If
you make over $150,000 a year, you can’t take any of the losses
against your income. Between $100,000 and $150,000, the amount you
can deduct phases out.
And that’s when a previously little-used tax designation became very
popular. It’s called the Real Estate Professional status. Since 2007, and
the crash of real estate values, it’s become more common. But, not
everyone is using it correctly.
First, let’s look at what this is and why it was such an important piece
of tax strategy. If you didn’t report or aren’t interested in claiming a
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real estate professional status on your tax return, or even care what
that means, skip over to “Active Participation”.
What is a Real Estate Professional?
By “real estate professional”, we mean the definition that the Internal
Revenue Code and other categories of tax law specify. It doesn’t
mean, necessarily, that you are a licensed real estate agent or broker.
And, unlike some so-called real estate goo-roos have claimed, you
can’t self-specify that you are a real estate professional. You have to
pass very specific IRS tests to qualify. If you do qualify, you get to
take unlimited real estate losses against your other income.
There are actually three IRS tests to determine if you are a Real Estate
Professional.
First of all, there is a test of hours that you or your spouse alone must
use to qualify. You can’t combine hours to qualify. It is one or the
other.
You must have:
(1) Spent more than half of the time you worked performing
personal services in ALL trades or businesses doing “qualified real
estate activities.”
AND
(2) More than 750 hours for the year were spent preforming
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“qualified real estate activities.”
If you have no outside employment or no obvious trade or business
(such as with a Schedule C, business return) then you only need to
pass Test 2.
That’s Test #1.
Test #2: You must have qualifying material participation with your
property.
Material participation is defined (for real estate) as one of the
following:
(1)
500 hours or more of activity with the property,
(2)
100 hours or more and more than any other person, or
(3)
More than any other people combined.
If you have a property manager, the IRS is going to require you to
have 500 hours or more. This isn’t written in the Code or Regulations,
it is simply their current interpretation of the law.
If you’re married, you and your spouse can combine your hours for
this test.
Test #3: Each property must stand-alone.
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At the end of the written portion of this handbook, you’ll see an
excerpt that IRS auditors will use to question you about your material
participations and Real Estate Professional status.
Active Participation
There are two standards for participation in your real estate
investment: active participation and material participation. If you
make less than $100,000 per year, you can take $25,000 of your real
estate loss against your other income provided you have active
participation.
Active participation means that you spend at least 100 hours per year
in activities specifically related to your real estate holdings.
How to Write Off Your Real Estate Passive Losses Against Other
Income
If your income is under $100,000, there are two rules:
(1)You must actively participate in the real estate investment(s), and
(2) Allowable loss is limited to $25,000.
If your income is over $150,000, you can’t take a loss. Between income
of $100,000 and $150,000, the loss amount phases out.
Active participation in the property is required no matter what. No
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active participation and you don’t have a deduction.
IRS AUDIT POINT: The IRS wants proof that you are ACTIVE and
that means getting out from behind your computer. They will most
likely disallow all or a large portion of hours spent surfing the
Internet and looking at listings online. They also don’t like it if your
only check-in with the property is via periodic phone calls with a
property manager. They want to see that you are truly ACTIVE in
regards to these properties.
Material Participation
A lot of people focus on meeting the 750+ hour test to meet the Real
Estate Professional status requirement so that they can take a real
estate loss deduction when their income is over $150,000 and forget
about the material participation rule.
Real estate activities are in one of two categories: passive, or
materially participating passive. Somehow that makes sense in the
IRS world.
If you have a passive loss, it can only be used against passive income.
Period. There are no loopholes.
Materially participating passive losses, on the other hand, can be
used against materially participating passive income and, in some
cases, other income. That’s where the gold is for most real estate
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investors. It’s where the loss from real estate investment can be used
to offset other income. But, please note that unless you materially
participate, you can’t take the losses against other income.
Mistake #1 with Material Participation
By definition, if you hold property in a limited partnership as a
limited partner, you do not materially participate. This problem does
not exist for a member in a Limited Liability Company (LLC). The
IRS handbook has a series of questions regarding limited
partnerships, so be prepared for this question if you’re audited. In
fact, the number of audits of limited partnerships is way up, so you
might get this question way sooner than you expect.
Mistake #2 with Material Participation
The material participation rule requires that you work 500 hours on
each property. If you have 10 properties that means you have to work
a total of 5,000 hours. There is one way around it. You can make an
election with your tax return that aggregates the properties so that
you only have to meet the requirement of 500 hours in total.
Tax Tip: The aggregation election needs to be only done once for the
properties. If you add more properties, you’ll need to make a new
election. This election can be made at an entity level if the property is
held in a partnership or S Corporation, or it can be made personally.
Once done, the properties are all aggregated for life, more or less.
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You have to purposely undo the election by proving that the
circumstances have changed. You are allowed to aggregate because
the properties and your work with are similar. So to undo the
election, you must prove that they have become dissimilar.
The biggest problem with the aggregation election occurs if you sell
one of the properties at a loss, you are not able to immediately take a
loss for the property against your income. Instead the loss stays
inside the aggregated group to offset future gains from sales. To take
the loss, you will need to make the election to de-aggregate the
group.
You can aggregate later and do a retroactive election. That may be the
best strategy because there is no downside and if you later find you
need to sell a property at a loss, you don’t have to unwind a
mistimed election.
Mistake #3 with Material Participation
You must have 500 hours of activity per property to count as material
participation if you have a property manager. The aggregation
election (above) will get you out of having to work 500 hours per
property, but you’ll still be required to get 500 hours in total if you
have a property manager.
You Need to Produce a Time Log
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It is now 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 are also taking a mileage deduction, record that,
too). Take pictures at the property to further document your record.
Active or Material Participation?
There are two standards for participation in your real estate
investment: active participation and material participation. If you
make less than $100,000 per year, you can take $25,000 of your real
estate loss against your other income provided you have active
participation.
Active participation means that you spend at least 100 hours per year
in activities specifically related to your real estate holdings.
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 new 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
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during your audit. We’ve identified each issue for you, along with
our analysis on 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.
Tax Tip
Keep a camera in your car or purse. When you’re on a job site, take a
picture (or better yet, have someone else take your picture). Now
you’ve got some physical evidence of your activities.
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
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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.
Issue: Automatic Adjustments due to Passive Loss Limitations
(continued)
If AGI is over $150,000 then in most cases the partner’s MAGI is also
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
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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
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
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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.
Tax Tip
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 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.
Documents the IRS Will Request
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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 most 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 business
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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 non-passive
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- employment
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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.
If the taxpayer is not a real estate professional (Schedule E line 43 is
blank):
Have partnership losses been entered in the non-passive 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
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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
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
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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.
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
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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
real estate of a real state 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
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one-half of self- employment 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.
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
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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
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: The IRS is now allowing you to make late
aggregation elections. You may want to wait until it’s absolutely necessary.
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.
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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 this), what the guaranteed payments were
for. 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
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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).
If an individual partner’s return is open and the issue is solely
meeting the hourly tests for material participation in Treas. Reg.
section 1.469-5T(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
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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;
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.
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Documents the IRS Will Ask For
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
work papers or any other documentation indicating rentals
were grouped.
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
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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 it is a strong
indicator that you did not materially participate. Because this is a
critical question to the 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
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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.
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
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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 nonmanger, 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.
Examination Techniques the IRS Will Use
At the initial interview, they will ask what services
each partner performs for the partnership. Inquire how often
each partner is at the partnership’s business location.
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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 location is a significant distance from the
partner’s residence;
o No guaranteed payment on Schedule K-1 line 4.
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
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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?
What records does the partner have to substantiate
hours worked?
Is each partner directly involved in day-to-day
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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.
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
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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 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.
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