Real Estate Professionals

5/13/2013 - By Brett Snyder, J.D., LLM

The "Reasonable Means" Requirement

Owning rental properties can be a great way to supplement income. However, taxpayers who own rental properties generally encounter a common downside: any losses incurred from their rental activities cannot be used to offset their other non-rental income (such as wages or salary). This is due to the Tax Code generally deeming all rental activities as passive activities regardless of the level of participation by a taxpayer. Generally, these passive losses can only be deducted from income generated from other passive activities.

However, Congress added an exception to the Code in the early 1990s that allows materially participating "real estate professionals" to treat rental income and losses like income and losses from other activities. Thus, if a taxpayer is able to qualify as a real estate professional, rental losses can be fully deducted against non passive income (such as wages, business income, or investment income), so long as the taxpayer's participation is material.

Do I Qualify?

Qualifying as a real estate professional involves passing a two-pronged test:

The taxpayer must spend more time materially participating in real estate trades or businesses than in any other jobs combined, and
The taxpayer must spend more than 750 hours materially participating in a real estate trade or business in which the taxpayer is an owner.

Whether or not a taxpayer qualifies as a real estate professional may seem fairly straightforward. However, taxpayers have been routinely rebuffed by the I.R.S. and the courts when trying to prove the requisite participation thresholds have been met. Confusion has set in among taxpayers due to the vague nature in which a taxpayer's level of participation may be proven: through "any reasonable means". While a clear bright-line standard has not been defined, the Tax Court has stated that "reasonable means" are not a post-event "ballpark estimate."

However, one item remains clear: the "any reasonable means" standard should not be misconstrued by taxpayers as being a lenient one.

In fact, the amount of evidence and the type of documentation that has been required of taxpayers is nothing short of copious and meticulous. Thus, taxpayers hoping to qualify should keep the following points in mind throughout the year:

Activity records should be prepared contemporaneously with the activity. A daily record of the time spent on rental properties will likely be the taxpayer's best and most reliable form of evidence when faced with a challenge by the I.R.S.
Noncontemporaneous, reconstructed post-event records (such as time logs, date books, or desk calendars) are sufficient as long as the narratives are supported by other objective and reliable forms of evidence (such as testimony, emails, receipts, work orders, or other documents).
The courts do not have to treat a taxpayer's unsubstantiated self-serving testimony as true even if their testimony is found to be credible and reliable.
A post-event narrative should be constructed in good faith.
The records should not reflect an implausible result. For example, if a taxpayer spends 40 hours per week working a full-time non-real estate job, it would seem improbable that the taxpayer would also spend at least 41 hours each week managing rental properties as well.

Closing Thoughts

So, what does all of this mean for taxpayers hoping to qualify as a real estate professional?

Clearly, it will be very difficult for a taxpayer who works full-time in a non-real estate job to qualify as a real estate professional. Furthermore, qualifying as a real estate professional can be easily derailed by sloppy recordkeeping.

Most importantly, remember that qualifying as a real estate professional only makes it possible to have non-passive losses from rental activities. That said, the real estate professional must also materially participate in the rental activities. If an election to combine all rental activities is made, the taxpayer can materially participate by working at least 100 hours between all of the rental properties. Otherwise, the taxpayer will be required to materially participate for at least 100 hours in each rental activity in order to treat the losses from the activity as nonpassive.

Fortunately, unlike the test for real estate professional classification, the time of both spouses is counted under the material participation tests regardless of whether or not a joint return is filed. The documentation and records the taxpayer used to qualify as a real estate professional will also establish whether the taxpayer has materially participated in the rental activities.

"Obamacare" Implications

With the Supreme Court holding that the Affordable Care Act is constitutional, the new 3.8% tax on certain taxpayers who generate "net investment income" through passive activities (which includes rental income) will continue being implemented. Thus, the real estate professional designation will only continue to grow in importance to taxpayers hoping to escape the extra tax.

As a result, it will be unsurprising to see the number of challenges the I.R.S. issues to taxpayers claiming real estate professional classification in the future grow as well. Accordingly, taxpayers need to get in the habit of diligent record keeping sooner rather than later.

- Brett Snyder, J.D., LLM (Tax)