Real estate professional status under IRC §469(c)(7) depends on how many hours a taxpayer works, and where. If the return is examined, the taxpayer must be able to prove those hours. This article explains what has to be shown and practical ways to document it.
What Has to Be Proven
To qualify as a real estate professional for a year, a taxpayer must show both of the following:
More than half of all personal services performed in trades or businesses during the year were performed in real property trades or businesses in which the taxpayer materially participated.
More than 750 hours of services were performed in those real property trades or businesses.
To treat rental losses as nonpassive, the taxpayer must also show material participation in each rental activity, or in the combined activity if the election to aggregate all rental real estate interests was made.
Good records therefore cover three things: hours in real estate activities, total hours worked in all trades or businesses (including any job as an employee), and participation in each rental activity.
The more-than-half test compares real estate hours with all working hours. A taxpayer with another job or business needs records of that time as well, not only a log of real estate work.
What the Regulations Require
Treas. Reg. §1.469-5T(f)(4) provides that participation may be established by any reasonable means. Contemporaneous daily time reports or logs are not required if participation can be established by other reasonable means, such as identifying the services performed over a period and the approximate hours spent, based on appointment books, calendars, or narrative summaries.
Even so, specific records made during the year generally carry more weight than summaries prepared later. Courts have often rejected participation claims supported only by rough, after-the-fact estimates.
Building a Reliable Record
A practical log records, for each entry, the date, the property or business involved, the task performed, the time spent, and any supporting item, such as an email, invoice, or work order. For example: “March 14: Unit 2, 120 Main Street. Screened two rental applicants and prepared lease. 2.5 hours. Applicant emails on file.”
Calendars, phone records, emails and texts with tenants and contractors, invoices, bank records, mileage logs, and dated photographs can corroborate the log. Updating the log weekly, rather than reconstructing it at year-end, makes it far easier to support.
What Counts and What Does Not
Hours generally count when the taxpayer does the work of operating the real estate business, such as showing units, screening tenants, negotiating leases, arranging and overseeing repairs, collecting rent, and keeping the books.
Some time does not count:
Work done as an investor, such as reviewing financial statements or reports, preparing analyses for one’s own use, or monitoring operations in a non-managerial capacity, unless the taxpayer is directly involved in day-to-day management or operations.
Work not customarily done by owners, if one of its principal purposes is to avoid the passive loss rules.
Services performed as an employee in a real estate business, unless the taxpayer is a 5% owner of the employer.
A spouse’s hours cannot be added to the taxpayer’s hours for the 750-hour and more-than-half tests; one spouse must meet both tests alone. A spouse’s participation does count, however, in determining material participation in an activity.
Keeping the Record Consistent
Records are easier to support when they fit with other evidence. If a property manager handles day-to-day operations, the log should show what the owner personally did rather than duplicating the manager’s work. If the taxpayer also has a full-time job, the real estate hours claimed should be consistent with that job’s schedule, and the records of total working hours should show that real estate work was more than half of the total.
If the Status Is Not Established
Rental losses that are passive are not lost. They can offset passive income, may qualify for the $25,000 allowance for owners who actively participate in rental real estate if adjusted gross income is low enough, and otherwise carry forward until there is passive income or the taxpayer disposes of the entire interest in the activity in a fully taxable transaction.
The Bottom Line
Real estate professional status is a factual question decided on the taxpayer’s own records. A log kept throughout the year, tied to specific properties and supported by other documents, together with a record of total working hours, provides the strongest foundation.
Facing questions about real estate professional status?
Tax attorney Cassra Minai, Esq. can review your situation in a confidential consultation.