Audit. It’s the word most real estate investors dread. But that is precisely what could happen as part of a “sweep” the IRS is conducting across the U.S. that calls into question deductions real estate investors have routinely been taking for years.
As real estate investors are aware, Congress allows deductions pertaining to the operation of real estate. Replacing damaged walls, installing new carpeting, and buying new sinks are all typical costs that your CPA would allow you to expense in a taxable year.
However, the Treasury Department has determined that there are tax compliance issues and abuse related to who is entitled to take deductions related to real estate ownership. As a result, the IRS has dramatically stepped up its audits of taxpayers who take significant deductions related to their real estate holdings, on the theory that investors are not real estate professionals and as passive investors must actually defer the deductions until the properties are sold.
The issue at stake is timing, or when real estate investors are permitted to take deductions. It might come as a surprise to a real estate investor that the IRS is taking the stance that typical deductions for expenses, such as improvements, depreciation and repairs, are only available after the sale of the property. Unless they qualify under certain rules, investors must “store up” these deductions (or “defer” them in the parlance of tax professionals).
The IRS stance really dates back to 1986, when Congress strengthened Section 469 of the Internal Revenue Code. Section 469 was an attempt to limit the current deductibility of expenses to only those investors who materially participated in managing their real estate investments, and for rental real estate, to limit the deductions to real estate professionals. Under these rules, investors deemed “passive” were not permitted to take standard real estate deductions if they exceeded the income a property generated. The switch was aimed at preventing passive investors from taking deductions to offset income from their “day jobs.”
Where the issue gets confusing is making a distinction between passive and “active” investors. Passive investors may be easier to define. They are investors who make monetary investments in a real estate project and then let other people – management companies or real estate syndicates – take care of the investment. At the end of the year, they receive K-1s reporting the flow-through of income and deductions.
So if this definition does not fit an investor, then he/she must be an active investor, right? Wrong. To be considered an active investor under provisions of Internal Revenue Code Section 469, an investor must: (1) be a real estate professional; and (2) “materially participate” in the real estate operation.
There is a common misperception that you must be a real estate developer, broker or sales person to qualify as a “real estate professional.” However under the Internal Revenue Code, to be deemed a real estate professional, a person must:
(1) spend more time working on their real estate than any other job (51%); and
(2) spend at least 750 hours working on their real estate trade or business.
A real estate trade or business is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.
The definition of “material participation” gets a little trickier. IRS auditors are fond of taking the position that investors materially participate if they spend at least 500 hours doing real estate-related activity on a particular property. Your material participation is measured on a property by property basis. However, Section 469 allows for a one-time election on your tax return to treat all properties as if they were one. After this election, which remains in force until it is revoked, investors can accumulate hours worked on all properties to reach the necessary 500.
In addition, the 500-hour per property test is just one of seven “safe harbors” – or interpretations of the tax code contained in Treasury Department regulations – for material participation. Others tests may be easier to pass than the 500-hour test. For example, if an investor is the only person working on a property, that property qualifies. So, if an investor owns a rental house and does all the work on it, such as collecting rent and fixing the plumbing, then the investor materially participates. Likewise, if more than one individual works on a property, (e.g., in the case of a partnership), and the real estate investor under audit works more than 100 hours on a property and more than anyone else, they are materially participating under the regulations.
Now comes the ugliest part. How do investors prove the time they’ve spent working on properties? Unlike accountants or lawyers, investors’ time is not accountable to clients and, therefore, most investors do not keep contemporaneous logs. Unfortunately, the IRS contends that unless investors can objectively prove time spent, they cannot count it.
So how do investors protect themselves? Although it is not required under the Internal Revenue Code, keeping a contemporaneous log that details minute-by-minute activity is the best way to keep the IRS at bay. If the IRS comes knocking on your door for an audit, there will be no issues if you can prove the requisite hours for being a real estate professional of 750 hours based on contemporaneously created written time logs.
But what about investors who face audits, but have not kept logs? Under this scenario, they should make a list of the tasks performed in any given year on a property. Some examples are reading a lease, reviewing escrow statements, calling plumbers, or scheduling electricians. Next, they should calculate the time spent on each task for each property owned. While not as good as a contemporaneous log, this constitutes a reconstruction of an investor’s time. Although the IRS may not accept it, it can be used in tax court if litigation is pursued.
The best illustration of this is to think of a chain-link fence. Without a contemporaneous log, in order to move across the fence you must provide a substantiating document for each link in the chain. The first link would be the list of tasks performed on each property. The second link would be the documentation you referred to in creating the reconstruction. The final link would be the reconstruction of hours identifying the tasks you performed and the documents that you used in creating the reconstruction. For example, if you own a condo that you rent to a tenant, the lease you created might remind you that you spent three hours preparing it and negotiating it with the tenant. A plumber’s invoice might remind you that the tenant called you on the phone and had a plumbing emergency, and you spent a specific number of hours dealing with the problem. Ultimately, you will come to an annual total of your hours related to each property you own.
If a case does reach tax court, then it is up to the judge to assess an investor’s credibility. To prepare themselves in the event of a trial, investors should obtain affidavits from people who can corroborate time spent. For example, a leasing broker can testify that an investor negotiated the terms of a lease with a potential tenant and a plumber can testify that it was the investor, not a management company, who called him to fix a leak.
I have represented numerous real estate investor clients in the United States Tax Court who easily met the various hour requirements; however, they were also employed by a corporation and receiving significant W-2 income. The IRS auditor almost always assumes that if you are making good money on a W-2, you can’t possibly be spending more time on your real estate investments than you are at your day job. In order to prove that you do in fact spend more time on your real estate, you will need independent objective substantiation from your employer of the time you spend at your other job.
Although it is a lot of work, it is important to take these steps, particularly for investors who own multiple properties generating significant deductions. The tax ramifications can be staggering, so being informed and prepared is the best way to arm yourself against a potential audit.
Philip Garrett Panitz is a tax attorney and a certified tax specialist who holds an LL.M. in taxation from New York University. He litigates tax court cases against the IRS in California and nationwide. In 1995, he argued the landmark tax case Williams v. U.S. to the United States Supreme Court, leading to a victory that changed the way the IRS can seize properties from third parties. He can be reached at firstname.lastname@example.org or 877-FED-TAXS.