Refresher on What is a Real Estate Professional and the Importance of Time Logs
By Stephen Gilman, Partner, Tax & Business Services
The passive activity loss rules introduced as part of the 1986 Tax Act made it more difficult for passive investors to deduct losses from investments against their other ordinary income. One way taxpayers can avoid such disallowance is to “materially participate” in the activity by spending at least 500 hours in such activity. This may be difficult to do if the taxpayer has a full time job.
Real estate is per se passive, so even if an investor spends 500 hours in one real estate activity, passive losses from that activity can only be used to offset income from other passive activities, with excess losses being carried forward to future years.
These rules eliminated the ability for a doctor, for example, who had a full time medical practice from purchasing an investment in real estate, from using any losses generated to offset ordinary income earned in the medical practice.
An exception to the rule that real estate is per se passive exists for taxpayers that are truly in the real estate business (professionals) in accordance with the Internal Revenue Code. This exception requires that the following two tests are met:
- Taxpayer spends at least 750 hours in the real estate property trades or businesses in which taxpayer materially participates.
- Taxpayer spends more than 50% of personal services in trades or businesses in real estate property trades or businesses that taxpayer materially participates in.
Investors with several real estate properties are permitted to make a tax return election to “aggregate” activities when claiming to be treated as a real estate professional.
The biggest advantage to claiming to be a real estate professional has traditionally been the ability to utilize losses generated from the real estate to offset other ordinary and investment income. If the real estate always generated income, there was generally no advantage to being treated as a real estate professional.
This changed on January 1, 2013 when the net investment income tax (NII) rule was introduced. The NII caused taxpayers whose modified adjusted gross income exceeded $200,000 ($250,000 on a joint return) to pay an additional 3.8% tax on investment income including passive income. Taxpayers in the real estate business who in the past were profitable, now had a new incentive to claim real estate professional status as the real estate earnings would not be deemed investment income subject to the 3.8% additional tax.
How do individuals prove to the IRS upon audit, that they are truly real estate professionals and that have accumulated the required hours?
The IRS indicates that taxpayers can use “any reasonable means” to make this determination. However, several court cases have shown that “any reasonable means” is not as good as a contemporaneous time log. It is far better to document on a daily basis all of the activities performed in the real estate business. This has proven to be far superior proof than a reconstructed “guestimate.”
We strongly recommend the keeping of a contemporaneous time log if you are claiming to be a real estate professional.
Please contact your Marcum Tax Advisor for guidance on keeping these records.