Real estate professional status can allow rental losses to offset wages and other nonpassive income, so the IRS may examine these claims closely. This article explains the legal tests, what an examiner may request, and how to document participation.
Why the Status Matters
Under section 469 of the Internal Revenue Code, rental activities are generally passive, and losses from passive activities can offset only passive income. Real estate professionals are an exception: a rental real estate activity in which a qualifying real estate professional materially participates is not treated as passive.
Because the status can determine whether substantial rental losses are deductible in the current year, the IRS may scrutinize the claim, and the taxpayer bears the burden of substantiating it.
The Two Annual Tests
A taxpayer is a real estate professional for a year only if both of these tests are met, as described in IRS Publication 925:
More-than-half test. More than half of the personal services the taxpayer performed in all trades or businesses during the year were performed in real property trades or businesses in which the taxpayer materially participated.
750-hour test. The taxpayer performed more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participated.
Real property trades or businesses include developing, redeveloping, constructing, reconstructing, acquiring, converting, renting, operating, managing, leasing, and brokering real property.
Details That Often Decide the Outcome
Employee hours. Services performed as an employee do not count toward the real estate side of either test unless the taxpayer is a 5% owner of the employer. Those hours still count in the total used for the more-than-half test.
Spouses. On a joint return, the spouses’ hours are not combined for these two tests; one spouse must meet both tests on his or her own. A spouse’s work does count, however, when measuring material participation in an activity.
Material participation in each activity. Meeting the two tests is not enough by itself. The taxpayer must also materially participate in each rental activity, unless the taxpayer elects to treat all interests in rental real estate as a single activity. Material participation is measured under seven tests, including participation of more than 500 hours in the activity during the year.
Investor-type work. Work done in the capacity of an investor, such as reviewing financial statements or monitoring operations in a non-managerial role, generally does not count as participation.
The Challenge for Taxpayers With Full-Time Jobs
The more-than-half test compares qualifying real estate hours with all hours worked in every trade or business, including a job. For example, a taxpayer who works 2,000 hours a year as an employee (and is not a 5% owner of the employer) would need more than 2,000 hours of qualifying real estate services in the same year to pass the more-than-half test.
For this reason, the status is most attainable for people whose principal occupation is in real estate, or for a spouse who does not have other full-time work.
What an Examiner May Request
Time records showing dates, properties, tasks, and hours.
Evidence of other work, such as employment records or business calendars, to test the more-than-half calculation.
Corroborating documents, including emails and texts with tenants, contractors, and property managers; invoices; leases; and bank and credit card records.
Management agreements, which show which tasks a property manager performed rather than the owner.
The election statement, if the taxpayer elected to treat all rental real estate as a single activity.
Documenting Participation
Participation may be established by any reasonable means. Contemporaneous daily time reports are not required if participation can be shown in another way, such as with appointment books, calendars, or narrative summaries. Even so, records created during the year and supported by third-party documents are generally easier to substantiate than estimates reconstructed after an examination begins.
Practical steps include recording real estate work as it happens, keeping the documents that support each entry, excluding time that does not count (such as investor-type activities), and keeping an accurate record of hours spent in other work.
Real estate professional status must be established each year: more than 750 hours, more than half of all working hours, and material participation in the rental activities. Credible, corroborated records are the foundation of the claim.
If the Claim Is Not Accepted
If the IRS concludes that a taxpayer was not a real estate professional, the rental losses generally are treated as passive. They are not permanently lost: disallowed passive losses carry forward, can be used against passive income in later years, and generally become deductible when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction to an unrelated party. Depending on income, part of the loss may also qualify for the special allowance of up to $25,000 for active participants, which phases out between $100,000 and $150,000 of modified adjusted gross income.
The adjustment can still produce additional tax, interest, and in some cases a 20% accuracy-related penalty. A taxpayer who disagrees with the examiner’s findings can generally request review by the IRS Independent Office of Appeals and, after receiving a notice of deficiency, may petition the U.S. Tax Court.
Is your real estate professional status under examination?
Tax attorney Cassra Minai, Esq. can review your records and the issues in your examination in a confidential consultation.