The IRS is on the warpath against real estate investors. Perfect. You’ve taken money out of the failing stock market, or prudently decided to put it in real estate before the stock market even sniffed apocalypse. You have your rental properties in Los Angeles County, or your rental homes leased out in South Orange County. Maybe you even have a few commercial office buildings in Ventura. You receive a telephone call from your friendly CPA, the same one that you invited over to break bread last holiday season. The words the CPA utters are almost unthinkable, bringing a sense of sheer terror to your mind, the IRS is going to audit your tax returns for 2009, 2010 and 2011.
All you can think to stutter is, Why? Did we do something wrong? Well, the answer to that question is somewhat debatable. If you are like a few thousand other real estate investors across the United States, you will soon find yourself a part of the sweep that the IRS is conducting. The IRS is taking the position that there is a compliance gap in this area of the tax law.
Owning real estate is not without its costs. Congress allows you deductions pertaining to the operation of your real estate investments. We all know about depreciation. There are operating costs: each damaged wall you repair, every new sink you buy, are part of the costs of owning rental real estate. A tenant moves out, and you are paying for new carpet and paint. Your CPA deducts every penny of it, and you don’t think twice about it.
Unfortunately, what Congress giveth on one hand, it taketh away on the other. In 1986, in a major tax overhaul, Internal Revenue Code section 469 was given some major teeth. In a nutshell, it says that if you are a passive investor, you don’t get to take these standard real estate deductions if they exceed the income the property generates. They are not lost; they just get stored up and are then magically released when the property is sold. Deferred, is the jargon we in the tax profession like to use to describe this phenomenon.
Wait, you protest! I am not a passive investor! What is passive, anyway? The answer to that question is easier to explain from the flip side, what is an active investor. The key gauntlet laid out by Section 469 is twofold: (1) Are you a real estate professional? Then, (2) Do you materially participate in the operation of your real estate? If you can answer in the positive to both of those questions, then the blockade of non-deductibility is lifted for you, and you may pass into the land of tax reducing bliss. But not so fast.
The term real estate professional is not what it sounds like. To a layman, the term sounds pretty simple on its face. If you ask the man or woman on the street, the answer will probably be any person that sells real estate for a living. Not in the macabre world of the Internal Revenue Code, which one Federal judge once described to me as a little more complicated than Greek. In the Internal Revenue Code, (and I am simplifying here), a real estate professional can be anyone that spends more than 750 hours per year working on real estate, and more than 51% of their working time is spent on real estate as opposed to their day job. For many of you, real estate is your day job.
Therefore, if you are a retired postal worker who bought an apartment building in Huntington Beach to rent out for an investment, you might be a real estate professional. If you spend 750 hours working on your real estate investments, and more than 50% of your time is spent on the endeavor, than you clear hurdle number one. This might be easier to prove for people that are retired from the day job grind. If you are a doctor working at Cedars Sinai making $2 million per year, the IRS might be a little skeptical when you try to show that you spend more time on your Manhattan Beach rental condos than on your practice.
Assume for a second that you have passed the first hurdle, and you are a real estate professional per the IRC. Now, you must pass the second hurdle. You must materially participate. An IRS auditor will almost always indicate to you or your CPA that in order to qualify as a material participator, you must spend at least 500 hours working on each property that you own. This statement is not exactly true. If you have a shrewd CPA, they have made an election for you on your tax return way back when, allowing you to lump all your properties together for the purpose of determining your material participation. If an election was made on your tax return, you can show an accumulation of time on all your properties collectively that total 500 hours. This avoids having to show 500 hours spent on each individual property. The election, once made, continues indefinitely until you revoke it.
However, the Department of the Treasury promulgates regulations interpreting the IRC, and these are authority when dealing with the IRS. The treasury regulations in this arena provide seven safe harbor tests to qualify for material participation. We have already discussed one of these, the 500 hour test. There are easier tests to allow you to qualify. One of the seven safe harbor tests defines material participation if you are the only one working on your real estate to the exclusion of anyone else. Under another test, you qualify if you spend more than 100 hours (per property, unless you made the election discussed above), and nobody else spends more time than you. For some reason, the IRS auditors seem to be unaware of these easier qualifiers and love to talk about the 500 hours per property test.
To combat these easier tests, the IRS sometimes takes the position that laborers working under your direction count against you in your quest for material participation hours. For example, if you are managing your apartment complex in Encino and you call a plumber to fix a shower that is leaking through to the apartment downstairs, the IRS auditors sometimes believe (erroneously in my professional opinion) that the plumber’s hours spent fixing the problem were hours that others spent working on your property. I think they are flat out wrong on this one, but no court has ruled on it. It probably is a non-issue for most real estate investors anyway, how many of you are going to spend less time on real estate related activities on your property than the time spent by your electrician and plumber and gardener combined? Not too many, unless you have one lemon of a property.
Now here comes the ugliest part of all. How do you prove that you spent this time working on your property? You are not a lawyer or a CPA, so you do not keep a minute by minute account of your time spent on your real estate investments. What for? Who are you accountable to other than yourself? Even lawyers and CPAs whom I have represented have not kept records when dealing with their own personal real estate investments. Unfortunately, the IRS is taking the position that if you can’t objectively prove the time you spend; you don’t get to count it. How do you account for those two hours that you spent on your Hermosa Beach rental house watering the petunias to get the thing looking nice to entice a potential tenant driving by on PCH? Your self-serving statements that you were up to your elbows scrubbing the floors for three hours at your Studio City apartment complex just doesn’t cut the mustard with the IRS unless you have objective proof. What does the IRS consider to be objective proof? A contemporaneously created log that details your real estate investments in a minute by minute detail of your time, and the activity you were spending the time on. Is this required under the IRC? No. Is the IRS insisting upon it to give you credit for your time spent? Yes.
From the perspective of a tax litigator such as myself, this is hogwash. But it is also reality. In trying cases before the United States Tax Court, you certainly can testify to the minute by minute details of your material participation. Most of you, however, would rather not hire me and settle the case at audit. I don’t blame you, litigation is expensive. But if an auditor is insisting upon a log that you were not by law required to keep, litigation may be your only option if the numbers that you are fighting over are large enough to justify fighting the IRS.
If you go to tax court, it is up to the judge to assess your credibility, and determine whether to believe you or not. As a practical matter, we are going to be bringing other witnesses who will corroborate your story. The plumber can testify that he got his marching orders from you, not some management company. Your real estate agent can testify that it was you that she went over the purchase and sales agreement with, and your leasing broker can testify that it was you who negotiated the terms of the lease with the tenants. Maybe you even have some good tenants that will testify that you were the person that they called when their neighbor’s dog wouldn’t stop barking.
More often than not, the Tax Court judges do not appreciate mere guesstimates. In other words, if you testify that you spent ten hours working on real estate leases for an apartment complex in Tarzana four years ago, the follow up question is likely to be: How do you remember that you spent exactly ten hours on that four years ago if you didn’t write it down? You’d better have a good plausible answer. Like a photographic memory. Or, as I like to say, you’ve been doing this for ten years and you know to a reasonable certainty how long it takes you to change a light bulb. And you have the receipts for a hundred light bulbs.
Philip Garrett Panitz is a tax attorney and a certified tax specialist, and has an LL.M. in taxation from New York University. He litigates tax court cases against the IRS nationwide. In 1995, he argued the landmark tax case Williams v. United States to the United States Supreme Court, leading to a victory that changed the way the IRS can seize properties from third parties. For more information, please call (805) 379-1667.