Are you a “Real Estate” professional in the eyes of the IRS?

It does not matter if you are a bookkeeper, Enrolled Agent, CPA, Attorney or an employee of the IRS the tax code is daunting and easy to misinterpret.  Even if you understand it the application of the regulation presents a further complication.  An area in my tax practice where I see mistakes routinely made is in the application of the title “Real Estate Professional”, section 469 of the IRS code deals with this topic specifically. 

Recently I was contacted by a potential client.  The IRS had sent him a notice that they were going to audit him.  He retained me for representation during the audit.  Being defined as a real estate professional is very advantageous to the tax payer.  The biggest advantage is that the passive activity loss limitations no longer apply.  Also real estate professionals are able to exclude rental income from the additional 3.8% tax on net investment income.  This client, named Jed had 3 rental properties and ran a business doing construction/home repairs and improvements.  He self-prepared his taxes by hand.  Between him and his wife they had a joint MAGI income which was in excess of $150,000.  He had claimed on his return that he was in fact a “Real Estate” professional.  But in speaking with Jed he wasn’t sure what the definition of one was for sure.  I explained a real estate profession in the eyes of the IRS has two main requirements and they are;

1. More than one-half of the taxpayer’s personal services must be performed in real property trades or businesses in which he materially participates; and
2. The taxpayer must perform more than 750 hours of service in real property trades or the businesses in which he materially participates.

If both tests are met the taxpayer is allowed to deduct all of the loss for the rentals in which he materially participates.  Material participation is defined by Treasury Regulation

Section 1.469-5T;

1. You participate in the activity for more than 500 hours during the year,
2. Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
3. Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than you,
4. The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours.
5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,
6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
7. A generic facts and circumstances test.

Most people who invest in rental property are not able to meet these stringent requirements.  In general passive income losses, which is what rental income is considered, are only allowed to offset passive gains.  The IRS gives a special allowance under section 469(i) allowing up to $25,000 of passive loss to be offset by earned income subject to income limitations and the requirement that the individual “Materially Participate”.  Should a taxpayer have more passive activity losses than they are able to offset in a given year those losses can be carried forward to future years.  In Jed's case he exceeded the allowable Modified Adjusted Gross Income amount of $150,000 disqualifying him from the $25,000 allowance provided by the IRS and was forced to use the “Real Estate” professional or carry forward the loss to a year where he might qualify to use it.

Luckily for Joe he met the two-part test required by the IRS to be considered a real estate professional.  In his primary profession of being a contractor he more than met the minimum time requirement.  Because he met the time requirement as a contractor this qualification extended over to his activities as a land lord.  Because he met the IRS requirements of the definition of a real estate professional he was then allowed to deduct the loss of his rental properties.  In Joe's case, he only had about an $8,000 loss for the year.  This loss ultimately saved him about $1,600 in the taxes he paid in 2016, as you can see the ability to meet the real estate professional definition of the IRS can be lucrative.

I represented Joe in front of the IRS for his audit.  The IRS auditor didn’t blink an eye when it came to Joe being considered a “Real Estate” professional.  I had Joe provide some simple documentation as to his hours, his activities and the auditor was satisfied with respect to the real estate professional definition. 

Scott Vance is a fee-only planner and Enrolled Agent at Taxvanta serving the Raleigh, N.C. area. He recently retired from the Army. His background allows him to uniquely understand issues faced by military personnel, but he works with all clients. He is currently a candidate for CFP® certification and seeks to provide objective, commission free advice to clients. Vance was born and raised in Pennsylvania. He is married to Amy. They have a son, Brandon. They enjoy skiing and kayaking. He can be reached by email at scott@taxvanta.com

Article Disclaimer: This article was written by a valued blog contributor but Triangle Real Estate Investors Association does not give legal, tax, economic, or investment advice. TREIA disclaims all liability for the action or inaction taken or not taken as a result of communications from or to its members, officers, directors, employees and contractors. Each person should consult their own counsel, accountant and other advisors as to legal, tax, economic, investment, and related matters concerning Real Estate and other investments.