The Tax Club Report

Over the last couple of years, a good number of taxpayers have been audited by the IRS for claiming the real estate professional election on their tax returns. It’s understandable that, like everybody else, the government is looking for ways to generate more revenue but the timing could not be worse. In this economic climate of tightened credit and the housing crisis, an aggressive IRS audit specifically targeting the people who are suffering the most cannot be good for anyone.

Why do people want to claim the real estate professional status on their tax returns? If you have real estate losses, you can only deduct $25,000 of the loss against your other income if you make less than $100,000. If you make more than $150,000, you cannot take any of the loss. Real estate professionals are not subject to this limitation and can take all real estate losses against their other income, no matter how much the loss or the income is. As long as you meet certain criteria provided by the IRS, you can reduce your taxable income and therefore, save money on taxes. This is the reason why so many people are eager to claim this designation and why the number and rapacity of the audits against real estate investors and professionals is increasing.

Requirements for Real Estate Professionals

According to the IRS, a real estate professional spends more than half of his time performing qualified real property activities. Real property development, construction, acquisition, conversion, rental operation, management, leasing or brokerage are examples of real property activities that qualify according to Section 469(c)(7) of the Internal Revenue Code. Time spent as an employee in real property activities counts only if the taxpayer is more than a 5 percent owner.

A taxpayer needs to spend more than 750 hours on an annual basis in real property businesses and rentals in which he materially participates to qualify for the real estate professional status. One materially participates in an activity if he or she works on a regular, continuous and substantial basis in the operations of a real estate business. It is possible to have a significant financial interest in a business, and yet not materially participate.

 What the IRS Scrutinizes During the Audit

The IRS has increased the number of audits on real estate investors and professionals and is taking a hard stand based on the unfavorable audit results and a few court cases that we have encountered. During the audit, the IRS will not just seek evidence of your material participation in the real estate business. They will also hone in on how active your qualified real estate activities really are. Any activity that smacks of passivity will be disallowed. Sitting at your computer looking at properties does not qualify as an active real estate activity. Nor does reviewing the monthly reports that your property manager sends you regularly no matter how frequent or how long it takes you to peruse these documents. The IRS wants to see evidence of regular physical activity in determining if you materially and actively participated in the real estate business.

Another thing that the IRS will scrutinize is the way you are holding your real property investments. If your property is held inside an LLC, they are going to require a copy of the LLC’s operating agreement to see if the appropriate verbiage is there. If the key phrases are missing or if the required special language that details your material participation is not there, you may find yourself owing a huge amount of money on taxes, not to mention interests and penalties. If you hold property in a limited partnership as a limited partner, you do not meet the material participation criterion and your losses will be disallowed.

Maintaining proper records is vital to having a positive outcome to the audit. Anyone looking to claim the real estate professional status must be keeping a detailed time log of dates, locations and activities, preferably substantiated with photographs or other proper evidence. If you feel confident that you meet the stringent requirements of the IRS and your activities will be able to withstand intense scrutiny, making sure your documentation is rock solid will serve you well in the event of an IRS audit. Please contact the Tax Club if you need more information on this topic at 866-840-1829 x5438.

Tags: IRS Audits, Real Estate, Taxes

This entry was posted on Monday, January 18th, 2010 at 3:54 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.