Investing in rental real estate is very attractive to high-income taxpayers because of the propensity for rental real estate to throw off tax losses while producing positive cash flow largely because of depreciation expense, which is a non-cash deduction. The use of section 1031 to defer tax gains into a subsequent piece of rental real estate by exchanging into the next property rather than by selling and then purchasing the next piece of property is very slick from a tax planning perspective as well.
Auditors routinely determine if the taxpayer is an employee early on in an audit in which case taxpayers must meet the 750-hour requirement to be a real estate professional strictly from time devoted to his rental real estate activities. Auditors take the position that being an employee takes a minimum of 2,050 hours a year which leaves little time to devote 750 hours a year to being a real estate professional. It is important to note that this hurtle is not impossible to meet but is often treated by the IRS under audit as impossible to meet.
If you are a taxpayer who believes you were treated unfairly during an audit and wish to seek audit reconsideration, file an appeal on this issue, and if the appeal is unsatisfactory go to tax court. I am David W. Klasing, a Los Angeles and Orange County real estate tax audit attorney with extensive experience handling every facet of this process.
I will apply my background as a tax lawyer and as a Certified Public Accountant (CPA) to your benefit. Contact my tax law office online or call 714-908-4467 or toll free 866-974-8429 to schedule a reduced-rate consultation. I am committed to representing clients throughout Orange County, Irvine, Los Angeles County, West Los Angeles, Westwood and surrounding areas.
Rental Real Estate Is By Definition Passive
To curtail the tax planning opportunities delineated above, Congress legislated that rental activities are by definition passive activities under Internal Revenue Code Sec. 469(1) and (2) whether or not a taxpayer materially participates in the rental activities or not. As a general rule passive activity expenses are limited by tax code to the amount of passive activity income. A taxpayer has a passive activity loss for the tax year if his or her losses from passive activities are greater than his or her income from passive activities for a given tax year.
Because of the passive activity rules, ordinarily rental passive activity losses are at worst non- deductible and at best partially deductible by congressional design. This harshness is somewhat mitigated by code sections that allow suspended passive losses to be carried forward and treated as deductions from passive activities in the following year, subject to the application of the passive activity limitations that are applicable in the following tax year. Moreover, suspended passive losses from a specific activity generally are allowed in full when a taxpayer disposes of his entire interest in the specific passive activity.
Two Exceptions to the Passive Activity Rules Surrounding Rental Real Estate
1. Active Participation
An exception to the passive activity rules allows a deduction of up to $25,000 of passive activity losses from rental real estate activities in which a taxpayer actively participates. However, the $25,000 limit is subject to a phase-out when a taxpayer's adjusted gross income exceeds $100,000 and is completely phased out at the $150,000 adjusted gross income level. The term "actively participates" above equates to material participation and is defined below.
2. Real Estate Professional Exception
An exception to the limitations on the deductibility of rental real estate losses is found under Code Sec. 469(c)(7), which dictates that rental real estate activity in which the taxpayer materially participates as a real estate professional is not treated as a passive activity and thus, losses from such activities are not subjected to the passive activity loss limitations.
A taxpayer is considered a real estate professional for this purposes of Code Sec. 469(b)(7) if he meets both of the following tests:
- Greater than 50 percent of all the personal services he or she performed during a tax year must have been performed in real estate trades or businesses in which he or she materially participated; and
- He or she must have performed more than 750 hours of personal services during the tax year in such real estate trades or businesses.
The service takes the audit position that one spouse alone must meet both of these tests. This seems to be in direct contradiction to Code Sec. 469(h)(5), which states that the participation of a taxpayer's spouse in an activity is attributed to the taxpayer for purposes of determining the taxpayer's participation in the activity. The service takes the position that while the spouse's time cannot be attributed to the taxpayer for purposes of the 750-hour test for the real estate professional designation, it may be attributed to the taxpayer for purposes of the additionally required material participation testing in each individual real estate activity discussed below.
Real Estate Trade of Business
A real estate trade or business is a trade or business that develops, redevelops, constructs, reconstructs, acquires, converts, rents, leases, operates, manages or brokers real property.
Material Participation
Generally, under Code Sec. 469(h)(1), a taxpayer's participation in an activity is treated as material participation if the taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. Under Code Sec. 469(h)(5), the participation of a taxpayer's spouse in an activity is attributed to the taxpayer for purposes of determining the taxpayer's participation in the activity. This attribution is allowable regardless of whether the spouse owns an interest in the activity and regardless of whether a joint return is filed for the tax year being tested. The regulations under §1.469-5T(a) delineate seven tests to determine whether a taxpayer is involved in the operations of an activity on a regular, continuous and substantial basis. Six of those tests are applicable to rental activities.
Rental Activity Material Participation Testing
If a taxpayer meets at least one of the following six tests, he or she is treated as materially participating in the rental activity during the tax year.
- The five-of-ten-preceding-years test. A taxpayer is treated as materially participating in a rental activity for the current tax year if the taxpayer materially participated in the rental activity for any five tax years, which do not need to be consecutive, during the 10 tax years that immediately precede the current tax year.
- The substantially all test. A taxpayer whose participation in a rental activity for the tax year constitutes substantially all of the participation in the rental activity by all individuals for the year, including individuals who are not owners of interests in the rental activity, is treated as materially participating in the rental activity.
- The not-less-than-others test. A taxpayer who participates in a rental activity for more than 100 hours during the tax year and whose participation in the rental activity is not less than the participation in the rental activity of any other individual for the year, including individuals who are not owners of interests in the rental activity, is treated as materially participating in the rental activity.
- The 500-hour test. A taxpayer who participates in a rental activity for more than 500 hours during the year is treated as materially participating in the rental activity.
- Significant participation activities test. A taxpayer is treated as materially participating in a rental activity if the rental activity is a significant participation rental activity for that taxpayer for the tax year, and his or her aggregate participation in all significant participation activities exceeds 500 hours for the year. A significant participation activity is a trade or business activity in which the taxpayer participates for more than 100 hours during the tax year, but does not otherwise materially participate within the meaning of any other five tests applicable to rental real estate.
- Facts and circumstances test. If a taxpayer does not satisfy any of the other material participation tests, he or she can be considered to materially participate in an rental activity for the tax year if, based on all of the facts and circumstances, the taxpayer participates in the rental activity on a regular, continuous and substantial basis for such tax year. For this test to be satisfied, however, the taxpayer must participate in the rental activity for more than 100 hours during the tax year.
Common Auditor Positions That Attack the Material Participation Testing or Real Estate Professional Designation
Under audit the IRS will often insist upon the taxpayer producing contemporaneous time logs to substantiate the time put into the rental activity. However, the regulations state that a taxpayer's participation in an activity may be established by any reasonable means. Moreover, contemporaneous daily time reports, logs, or similar documents are not required if the extent of the taxpayer's participation may be established by other reasonable means. Other reasonable means include the identification of services performed over a period of time and the approximate number of hours spent performing the services during that period based on appointment books, calendars or narrative summaries.
Auditors are known to skew participation testing by parsing out activities that case law has shown do not qualify as participation in the activity from the taxpayer's time substantiation. The following activities can be attacked in this manner:
- Time claimed for work that is not customarily performed by the owner of a rental activity is not treated as participation in the rental activity if one of the principal purposes of performing the work is to avoid the disallowance of a loss from the rental activity.
- Time claimed for work done by a real estate investor in his capacity as a real estate investor is not treated as active participation in the activity unless the investor is involved in the day-to-day management or operations of the rental activity. Work that auditors will attempt to parse out as non-qualifying includes studying and reviewing financial statements or reports on operations of the activity, preparing or compiling summaries or analyses of the finances or operations of the activity for the taxpayer's own use, preparing budgets, phone calls or visits to monitor operations, writing checks, trips to post offices and banks, preparing schedule E of the tax return, organizing records, reading journals and monitoring the finances or operations of the activity in a non-managerial capacity. It is very interesting to note the activities listed above are fully recognizable for material testing purposes where a rental activity rises to the level of a trade or business but are routinely disallowed and thus treated as non-countable where the activity only rises to the level of investment activity.
- If a rental activity has on-site management it takes the position that it is hard for a taxpayer to materially participate because rental activities by nature do not require significant day-to-day involvement and therefore are not time intensive. They take the position that of the five tests above, only the 500-hour test is applicable because of the on-site management. They will look at the taxpayer's other activities to see if 500 hours a year is even possible such as the manner in which the taxpayer earns his or her living. Auditors are known to equate on-site management with the activities of an off- site management company. It is important to note that property management companies often offer services on an a la cart basis and can be used for nothing more than to collect and remit the rent, which leaves plenty of activities necessary for the owner to perform. The auditors are trained to look for indications of on-site or off-site management companies by scanning for commissions, management fees, expenses for cleaning apartments, maintenance, repairs, etc. Each activity that is paid for that an owner could have done for himself is an indication of a lack of material participation.
Another common attack under audit is where the auditor takes the position that for purposes of applying the real estate professional exception, each interest that a real estate professional owns in a rental real estate activity is tested as a separate activity. In practice the auditor will often disallow the losses from a particular rental activity unless both the real estate professional exception rules delineated above are met and it can be shown that at least 100 hours of material participation can be substantiated per rental property.
To mitigate against this 100-hour requirement, a real estate professional should consider electing to treat all his or her interests in rental real estate activities as one activity. This election is made by attaching a statement to the original income tax return for the year that declares that the taxpayer is a real estate professional and that he is making the election under Code Sec. 469(c)(7)(A).
Auditors routinely determine if the taxpayer is an employee early on in an audit. Case law has held that personal services performed by a taxpayer as an employee are not treated as personal services performed in real estate trades or businesses unless the taxpayer owns more than five percent of the employer. What this means is that a taxpayer who is an employee must meet the 750-hour requirement to be a real estate professional strictly from time devoted to his rental real estate activities. Auditors take the position that being an employee takes a minimum of 2050 hours a year, which leaves little time to devote 750 hours a year to being a real estate professional. It is important to note that this hurtle is not impossible to meet but is often treated by the IRS under audit as impossible to meet.
Contact Our Los Angeles and Orange County Real Estate Tax Audit Attorney Today
Taxpayers who take the position that they are real estate professionals routinely find themselves under attack by the service. California does not recognize the real estate professional exception so exposure is solely a federal matter. The very audit guides that auditors perform their audits from do not, in my opinion, correctly state the law in the rental real estate arena.
The cold hard reality of the situation for taxpayers who feel that they were treated unfairly during an audit is that taxpayers only have a few courses of action to try and get fair treatment. The choices available are as follows: seek audit reconsideration on the issue, file an appeal, and if the appeal is unsatisfactory go to tax court. As a Los Angeles realty tax audit lawyer, I have extensive experience in every facet of this process and am ready, willing, and able to assist you should you find yourself in this situation. Contact my tax law office online or call 714-908-4467 or toll free 866-974-8429 to schedule a reduced-rate consultation.
