Recently, the Internal Revenue Service has stepped up its enforcement action against individuals who represent themselves on their tax returns to be real estate professionals. The IRS has been aggressively auditing individual tax returns of real estate professionals and reclassifying many of these individuals as passive real estate investors. According to IRS studies of tax compliance, many people are inappropriately deducting losses from real estate activities. If you are taking losses from real estate activities on your federal income tax return, your chances of an IRS audit have risen dramatically over the past year.
Among those selected for audit are individuals who are in fact bona fide real estate professionals within the meaning of the law, including licensed real estate brokers and agents. Based on our office’s experience, not all real estate professionals keep good records for the time they spend on real estate activities and, when confronted by the IRS, they often have difficulty proving that they meet the statutory requirements that can provide significant tax savings.
The advantage of being classified by the IRS as a real estate professional is obvious. A real estate professional recognized by the Internal Revenue Code can deduct the full amount of losses from her profession, including, but not limited to, depreciation, interest expense on loans, property taxes, travel-related expenses and office expenses. If the person is not recognized as a real estate professional, then she will be classified as a passive real estate investor, and his or her deductions will be limited by IRC § 469.
Typically the IRS treats all rental real estate activity as passive unless one of the exceptions applies. You are a real estate professional under IRC § 469(c)(7)(B) if:
More than half of the personal services the individual performs in trades or businesses during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and the individual performs more than 750 hours of service during the taxable year in real property trades or businesses in which the individual materially participates.
The term material participation is defined in IRC § 469(h) as regular, continuous and substantial involvement in the operations of an activity. Material participation must be satisfied with regard to each separate interest in rental real estate unless the individual has made an election to treat all interests in rental real estate as a single rental activity. See IRC § 469(c)(7)(A). If you own and manage several buildings, it is important that you assure that the proper election is filed by your tax professional or you will not be allowed to deduct your losses.
You must also substantiate and prove your material participation. Under Temporary Treasury Regulation § 1.469-5T, the extent of your participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs or similar documents are not required if the extent of your participation can be established by other reasonable means. Reasonable means for purposes of establishing participation may include, but are not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars or narrative statements.
We have found that while time logs are not required by law they have been proven to be particularly valuable in convincing IRS agents that our clients are eligible for treatment as tax professionals. Internal Revenue agents are not a group with a high level of trust in taxpayers, and some taxpayers have been forced to incur significant expense to appeal adverse determinations by an agent. Some are facing extended litigation to prove their status as real estate professionals. In short, even though you consider yourself to be a real estate professional, the IRS may force you to a very high standard of proof to retain the tax benefits provided to you by the Internal Revenue Code.
Robert D. Butters and Adam Fayne are lawyers with the Chicago law firm of Arnstein & Lehr LLP, and represent real professionals in tax compliance and other matters.