Real Estate Professional on Tax Filing

[dinkhelpneeded]

We have a 12 unit and a 8 unit purchased in 2014 and 2015 respectively.
We are considering filing as a Real Estate Professional by qualifying for the 2 criteria 750 hours (aggregate properties) as well as time spent on RE > Time spent on regular job

I hear the RE Professional exemption is a red flag for tax audit. I am trying to get a sense of people on this forum who have applied, and qualified, without an audit and to see if anyone has an opinion on whether we should back off from trying to get this exemption.

Review the points below and let me know if you think these are red flags for the IRS or if you have experience in this area

• The person qualifying as RE Professional will be my husband. We both have jobs, mine is FT (in consulting, so my hours are recorded), he works in a company partly owned by him, but still a w2 employee of the company (non RE related).
• My husband works on all RE related activities and we have diligently recorded dates and time spent doing certain activities, totaling >800 hours.
• Individual and combined income from W2 will definitely be MUCH greater than any rental income we have made from our properties.
• We have property managers for both properties.
• One is out of state, the other is in state but 1.5 hours away.

Debunk or Agree based on experience:
I hear that acquisition related hours and discussion with property manager do not qualify within the 750 hours.
I hear that if you are a landlord and not an agent/broker you MOST LIKELY will be audited and are likely to lose in court if they basically throw out all arguments on "hourly accounting" in court.

Even if you dont answer any of these, please narrate your experience with filing, that alone could be helpful!

[jviska89]

I have not tried to claim RE Professional status, but I was previously an auditor for the IRS and once audited someone who claimed the RE Professional status. Its been awhile so take everything I say and verify it still complies with the current IRC and Regs. I am going to assume two things about you. You show a Schedule E loss greater than $25k and/or your MAGI is greater than $150K. To be able to claim the loss against non passive income you must first pass the material participation tests and the passive activity tests. See link below. Some other notes:

1) Claiming RE Pro will likely increase your odds of being audited, especially if the IRS is currently working a program to audit real estate related issues. I do not know if they currently are.

2) High odds that they would not consider you as actively participating in the activity if you have property managers running the places.

I don't think I'd try to claim it if I were you. If you're going try,  KEEP EVERYTHING. An audit is not likely to happen for a few years and then BAM you're trying to find three year old documents. Also note receipts wear out, make copies.


This is a link that goes over how an IRS agent would audit you. It's not super straight forward, but lots of good info in the links.

https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Passive-Activity-Loss-Audit-Technique-Guide-ATG-Table-of-Contents

[dinkhelpneeded]

@jviska89

Your assumptions are right wrt losses and AGI. Thank you for the insight!

1. If the IRS debunks the RE Professional status, say after an audit, I understand they will make you pay back taxes plus some kind of penalty - I don't have a sense of if that penalty is severe or moderate. If I record my hours and the IRS later says those hours don't qualify (as I've read in some online articles/comments), then I assume I have to pay back taxes and interest but not sure how severe the penalty can be.

2. How painful is the audit?  In terms of time and effort and money ? I mean is there a threshold (based on experience)- for example if you save 100K in taxes, then risking an audit is worth it, but if tax saving is 20-30K then it might not be worth it.

[Another Reader]

The IRS will challenge both the real estate professional designation and material participation in your case.  Showing 750 hours engaged in the trade and business and the hours spent in the trade or business are greater than those spent in other employment are tough hurdles to overcome with property management in place.  In general, if your properties are managed by property management, you do not materially participate.  You may show active participation, but are unlikely to meet the material participation test. 

For an idea of how tests are applied, see the following article.

http://www.forbes.com/sites/anthonynitti/2014/11/19/the-top-ten-tax-cases-and-rulings-of-2014-6-the-irs-finally-figures-out-the-real-estate-professional-rules/#3518884a66f3

The issue is of importance to high income real estate investors because of the 3.8 percent surcharge on passive investment income, which is the issue addressed by the article, but the definitions are the same in your situation.

Another article that discusses the temporary regulations.

http://www.thetaxadviser.com/issues/2014/jul/skarbnik-july2014.html

In your shoes, I would do some more research before claiming RE Professional and material participation.

[jviska89]

@dinkhelpneeded

1) Yes you would have to pay back taxes, interest on those back taxes, plus any applicable penalties. Penalties applied in this case would likely be accuracy related substantial understatement and add at least 20% to the amount due. If they find you committed fraud it goes as high as 75% plus jail time (rare).

2) As scary as the above sounds audits can be painless if you acted in good faith while preparing your taxes and have all your documentation. The shortest audit I ever did was 1 day, the longest was over a year. If you hire a professional to represent you it will cost a decent amount.

Again, it is your call, but I would recommend carrying the loss forward and apply it again any future passive activity income and not try to claim RE pro status.