Are you a real estate professional? OK, that’s a trick question because you may have a business card that says you are, you may even go to your broker’s office a couple of days each week and tell your friends that you are a real estate pro, but if the IRS says you’re not a real estate professional you may find yourself with some big problems. Let me explain. I went to a meeting last month for an association of CPA firms that I belong to and one of the CPAs mentioned a tax audit a client of his was having and it was not going all that well. It seems the IRS has put together a new “audit initiative” to see audit real estate professionals are really meeting the tax-code definition of a real estate professional and if not they are disallowing rental losses that were taken that exceeded the passive-loss rental allowance.
The story is that most real estate professionals own some rental properties and they frequently generate tax losses but cash-flow positively mostly due to depreciation deductions. For most of us mortals these rental losses are passive and even if we actively manage the property they are limited to certain amounts depending on our reported Adjusted Gross Income (AGI). A real estate professional, on the other hand, does not treat these rental losses as passive but gets to treat them as active businesses and deduct all of the losses regardless of AGI.
Now comes the test for being a real estate professional. This is a “what have you done for me lately” type of test in that it is a test that needs to be passed for each year you treat a rental loss as an active business loss. Put simply, here is the test: you are qualified as a “real estate professional” for the year if you met both of the following requirements.
1. More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
2. You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
If you are a real estate professional with rental losses on your tax return you should be aware of the IRS audit program directed at you and be sure you are able to meet the above qualifications. If you have any doubts about this, and there are a lot more elements to be considered, I strongly recommend that you contact your tax professional to discuss all of the ramifications of this issue. And by the way, document, document, document…
Jeremiah K. Murphy, CPA is an accounting firm providing tax services, audits and business consulting.