If you're a real estate investor who has ever taken a real estate loss on your tax return, there is a target on your back. For months, members on my Forum have been complaining about being selected for audit, and losing, based on the IRS's new set of real estate professional guidelines.
Under tax law, a "real estate professional" isn't always a licensed real estate agent or a broker. It's a tax classification, and it's an important one. As a regular real estate investor, you are limited to deducting $25,000 in passive losses each year, against your passive income. That amount begins phasing out once your taxable income tops $100,000 and disappears entirely when your income reaches $150,000. Real estate professionals have neither the dollar nor the income limitation, making this classification an important part of tax-planning.
When the market got hot, the number of real estate professionals shot up. But as the "tax gap" (the difference between taxes that should be paid and taxes that are paid) increases, government is looking for ways to turn things around, and this classification is squarely in the cross-hairs.
To meet the IRS requirements, you need two things: spend the majority of your working time spent performing qualified real estate activities (regardless of what you do), and rack up at least 750 hours. Qualified activities include "develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease or sell" real estate.
Practically speaking you won't make the cut if you work elsewhere and report full-time W-2 income. And there's a third hurdle: material participation. In a twist that can only make sense in the IRS world, real estate activities are one of two things: passive, or materially participating passive. If you have a passive loss, it can only be used against passive income. Period.
Materially participating passive losses, on the other hand, can be used against materially participating passive income and, in some cases, other income. This is where the power of the real estate professional classification comes in: the ability to take the loss from real estate investments against other income. Unfortunately, what has been acceptable in the past, no longer is. Here are three areas the IRS is focusing on right now:
Limited Partnership Interests: By definition, if you hold property in a limited partnership as a limited partner, you do not materially participate. This area is being hit hard, and the number of audits of limited partnerships has increased.
Failure to Aggregate Hours Worked: The material participation rule requires that you work 500 hours on each property you own, or make an election to aggregate all the properties together into a single 500-hour block. Fail to make this election, though, and you will run into trouble.
Failure to Meet 500 Hour Threshold: To get even the $25,000 deduction you've got to meet the 500-hour minimum, even if you aren't going for full real estate professional status. Fail to meet this requirement and your passive loss will be limited to the amount of your passive income.
But the biggest change that we're seeing is to the material participation rules, and what does and doesn't constitute a real estate activity. For example, managing real estate is a qualified activity, but managing real estate through a third-party property management company is being challenged. So if you live hundreds of miles away from your rental properties, be on the lookout for this type of question. Another is research. The hours spent on researching properties and markets is being challenged by the IRS who consider this a passive activity.
Proper records are also becoming vital. Anyone looking to claim this classification must be keeping a detailed time log of dates, locations and activities, preferably backed up with photographs or other evidence showing you hard at work.
Finally, frustrating everyone is the fact that in many cases the "new" IRS rules (which came out in December of 2007) are being applied after the fact, and made retroactive to 2007 and earlier - when the old rules were still in force. Both sides are appealing up to the Tax Court, hoping to either set a new precedent or rein in the IRS. Until the Tax Court rules one way or another on whether or not the IRS can apply new rules to old earnings, we're in limbo. Reviewing your activities and taking steps to make sure you're in compliance with the new rules may be your best plan.