Deduction through Documentation: Supporting your Status as a Real Estate Professional
Kristin Redstone, Tax Principal
Think you can take losses from a rental property? Think again! Under Internal Revenue Code Section 469, losses from a rental activity are considered passive, which can be offset only against other passive income, and cannot be used to offset income such as wages or investment income. You may not necessarily be out of luck, though, when it comes to deducting rental losses. Section 469(c)(7) allows taxpayers who qualify as real estate professionals to treat their rental activities as an active trade or business, which generally allows them to deduct those losses.
According to Section 469(c)(7)(B), a taxpayer is considered a real estate professional by satisfying two tests:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
Taxpayers may elect to group multiple activities together into a single activity in order to meet the hour requirement.
One often-overlooked step is a taxpayer’s documentation of how the hours requirement was met. Under an IRS audit you may be required to provide a log or calendar of your daily work, including who you met with, where you went, what you did on the property, etc. In some cases, the IRS may accept a summary of a normal month of activity.
If you do not contemporaneously keep a log or calendar, recreating it could be problematic for you, and potentially cause you to lose the favorable real estate professional designation. Why? Because you not only need to qualify, you need to be able to prove that you qualified. In a recent case, Pourmirzaie v Commissioner (TC Memo 2018-26), recreating a calendar from memory ended up creating more questions than answers and the taxpayer’s argument collapsed under IRS scrutiny. The taxpayer created a calendar that showed work on specific properties for a week in September in California, but the IRS went as far as checking their bank statement for that week and discovered purchases being made in Philadelphia during the same time frame, rendering the recreated calendar nearly useless.
Recall that part of the two-prong qualification for status as a real estate professional includes a fraction that compares the time you spend in real estate activities to the total time you spend in all business activities. For this reason, the IRS may scrutinize not only your real estate activities, but also your non-real estate activities – especially if you are employed in a non-real estate activity on a full-time basis. Without careful documentation of the number of hours you spend in each category (even as an employee), the IRS could challenge your hours and cause you to fail the real estate professional tests.
Being considered a real estate professional could prove very valuable in reducing your tax burden. Not only will it potentially allow use of more losses, but income may be treated favorably as well. Current guidance is sketchy, but it appears that the income of a real estate professional represents one of the few ways that a new 20% deduction rolled out in December’s Tax Cuts and Jobs Act will apply to rental income. (More details on that may be found in additional BNN articles written in January and August.) However, the only way a legitimate deduction will be sustained is by proving it. Taxpayers should not only meet the tests outlined above, but also consistently and contemporaneously substantiate the time spent on services performed for their activities. That is the key to proving your favorable status to the IRS.
If you have any questions regarding status as a real estate professional, please contact Kristin Redstone or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.