The Difficult Task Of Defending Against An IRS Real Estate Professional Audit.

This discussion addresses IRS real estate professional audits when more than $25,000 of real estate loss is deducted against other income, a difficult type of IRS audit and one for which most taxpayers lose based on inadequate evidence.  If you have real estate rental loss over $25,000, if you want to deduct all of it against your other income, or if you are in or about to begin and IRS audit, then this discussion will greatly assist you.

This area of federal tax law is complex.  As a tax lawyer and certified public accountant with decades of experience, I understand these complexities, I understand audit and United States Tax Court procedure, and I will well defend you against an IRS audit of any kind including a real estate professional audit.   I advise you call me for a free consultation.  (877) 895-2950.

For decades, and continuing today, tax advisers persuaded investors to purchase and operate real estate rental properties, take huge depreciation deductions, write off real estate rental loss against other income like wages, investment income, and business income, all while having positive cash flow of rental income in excess of rental property costs. In 1986, Congress ended the practice of writing off these losses, called “Passive Activity Loss Rules”. In 1993, Congress carved out a narrow exception to the Passive Activity Loss Rules for “Real Estate Professionals” whom have real estate rental losses.  Federal courts’ litigated case decisions through the years have added complex evidence requirements.

Summary Discussion Of What You Must Prove To Deduct Real Estate Losses In Excess Of $25,000.

Generally, rental losses are not deductible, period. However, for real estate rental losses, if you or your spouse separately qualify as a “Real Estate Professional,” you remove the obstacle that generally real estate rental losses are not deductible. Obtaining real estate professional status does not mean you can deduct your realty rental loss, only that the general obstacle of so deducting is removed. To deduct real estate rental loss, you must also prove you and your spouse’s combined hours worked in your real estate rentals, satisfy one of seven separate and additional work standard rules called “Material Participation”.

In the following order, here is what you must prove, with evidence, to deduct all of your real estate rental loss over $25,000.  First, you must prove you have adequate “adjusted basis” to deduct your real estate rental losses {an accounting measure of your investment in realty rental properties}. Second, you must prove you have adequate “at risk” amounts concerning your investment in the real estate rental properties {another accounting measure of your investment}. Third, you must prove real estate professional status initially, and then you must prove you also met one of seven additional work standards called “material participation”.

When you deduct real estate rental losses on your form 1040 federal income tax return, schedule E, which are more than $25,000 for which you deduct against your other active income, YOU ARE AN IRS AUDIT TARGET!  IRS does lots of real estate professional loss audits and wins nearly every case due to poor taxpayer evidence records to prove they worked enough hours in real estate activities.

Detailed Discussion Of What You Must Prove To Deduct Real Estate Losses In Excess Of $25,000.

Condition 1: To Deduct All Your Real Estate Rental Losses — have adequate ADJUSTED BASIS.

Generally, you can deduct business losses, but only if you have adequate “adjusted basis,” stated in a simplistic accounting summary as follows:

+ acquisition costs of your realty rental properties;
+ capital improvements {improvements with a use life greater than one year};
+ contributed property
+ taxable income;
+ loans for which you personally are on the hook to pay;
– taxable loss up to adjusted basis.

In other words, the sum of this simplistic formula plus or minus other appropriate basis adjustments beyond the scope of this discussion, must be a positive amount more than the real estate rental loss sought to be deducted. If a year’s real estate rental loss exceeds the adjusted basis amount, that loss is suspended until such future year that adequate adjusted basis exists.

Condition 2: To Deduct Realty Rental Losses — be AT RISK.

Real estate rental loss deduction is also limited to the amount “at risk”, that amount equaling the money and adjusted basis of property you contributed to your real estate rental business, plus amounts you borrowed for which you are personally liable for repayment. In other words, you must be on the hook to lose the real estate you contribute to your real estate rental business, you must be have to repay loans personally, and the amount must be a positive amount more than the realty rental loss sought to be deducted. If a year’s real estate rental loss exceeds the amount at risk, that loss is suspended until such future year that adequate amount at risk exists.

Nightmare Condition 3: To Deduct All Your Real Estate Rental Loss, You Must Prove You Have REAL ESTATE PROFESSIONAL Status And You Must Satisfy One Of Seven Additional Work Standards Called “MATERIAL PARTICIPATION.”

In general, rental losses cannot be deducted, period, and are passive {meaning, you do not work enough in the rental business so you cannot deduct a net tax loss}, the consequence of which is that rental loss may only be deducted against passive rental income, no matter how many hours were worked in the rental business. Pursuant to this general rule, if real estate rental loss exist, such are passive losses which are suspended until such future time there is passive real estate rental income, or when you dispose of all your real estate rental properties.  Real estate rental losses that are passive may NOT be deducted against other non-realty rental passive income like interest and dividend income.

The Exception – “Real Estate Professional”.  However, as in many areas of federal tax law, there are exceptions. If you have real estate rental loss, if you can prove “real estate professional” status, and if you can additionally prove that you satisfied one of seven work standards called “material participation of regularly, continuously, and substantially,” relative to your work in your real estate rental business, then all of your real estate rental loss is nonpassive, the loss is active and deductible against your other income (i.e. interest, dividends, wages, business income). This federal tax law is complex, and I will next attempt to explain the law in easy to understand words, not in tax law jargon, as much as possible.

To obtain “Real Estate Professional status,” year by year separately, either you or your spouse separately,

(1) must have worked more than 50% of that person’s personal service hours, working specific kinds of real estate business activities for which the hours qualify as “materially participated”; and

(2) must have worked more than 750 hours doing any kind of real estate related work for which the hours qualify as “materially participated”.

You cannot combine your spouse hours worked for either of the two above requirements, but you can combine your spouse hours worked for the material participation tests discussed below. Also, if either you or your spouse were an employee in the real estate profession, those employee hours do NOT count towards real estate professional status, unless you own 5% or more of the employer.

The above paragraph might sound not so hard to claim and to satisfy, but it is not easy to prove with evidence that IRS or a federal court will accept!  Federal tax law, mostly litigated case law, requires that you prove real estate professional status for which you materially participated, with evidence that was created in the year at issue. Overall, federal tax law promulgated in treasury regulations state that your real estate hours worked evidence may be from any reasonable means, but federal litigated case law requires the evidence must have been created in the year at issue, not created years later for purposes of defending against an IRS audit.

Most taxpayers seeking real estate professional status during an IRS administrative audit, or by United States Tax Court litigation decision challenging IRS’ audit opinions, or in refund litigation, fail to prove with adequate evidence they qualify as a real estate professional, or fail to prove with adequate evidence that they satisfied any of the seven work standards called “Material Participation”.  This means that IRS’ auditors, IRS appeals officers, IRS lawyers, and federal courts’ judges,

i. will not accept your uncorroborated testimony about your compliance with these rules,

ii. will not accept your testimony corroborated by written records prepared after the tax year at issue,

iii. will not accept your testimony corroborated by the testimony of witnesses not having detailed, first-hand knowledge.

In order to prevail against IRS during audit, or in United States Tax Court, or in refund litigation in either the United States District Court or United States Court of Federal Claims, you must prove your real estate hours worked satisfy Real Estate Professional status, and you must prove you meet one of the seven additional material participation work standards with written evidence records created in the year at issue. It would also help if you have other persons’ detailed testimony that they personally observed you working those real estate rental hours themselves and in the year(s) at issue.

If you own real estate rental properties, if you have net real estate rental loss over $25,000, and if you desire to deduct all of your real estate loss against your other income, you MUST create during the year of this real estate rental loss, detailed accounting records of your real estate rental hours worked created in the year you seek to deduct your losses, and if you do not you will not win an IRS audit. The detail accounting records are documents like a calendar, appointment books, or written summaries, all created the same day or a few days later, and with detailed time entries like: “May 1, 2014, 9:15 am to 4:45 pm, met with realtor Joe Blow, and contractor Bill Fixit, to go over all conditions of rental lease for prospective tenant John Doe, at 123 Main Street, San Francisco, CA”, along with retaining whatever related paper documents existed for such a meeting. While this level of evidence strikes many as absurd hair splitting, this is what you are up against.

The Material Participation Standards: You Must Satisfy One Of Seven Additional Work Standards.

Even if you can prove that you or your spouse were a real estate professional, it does NOT mean you can deduct your real estate rental loss, it only means that the automatically not deductible obstacle is removed. Once real estate professional status is proven, you next must prove you satisfy one of seven additional work standards, known as “Material Participation” standards

[a] for all your rental properties together, but only if you filed an election in the year at issue or before with an original income tax return, to combine all your rental properties into an aggregate single realty rental business, or

[b] for each rental property separately if you did not file an election to combine all your rental properties into an aggregate single realty rental business.

For meeting one of the seven additional material participation work standards, you can combine your and your spouse’s hours worked in your realty rental business {spouse hours count for material participation, but not for real estate professional status}. To discuss each of the seven work standards is beyond the scope of this discussion, but if you desire to further torture yourself, study 26 C.F.R. § 1.469-5T, “Material Participation.”   

Election To Treat All Rental Properties As A Single Rental Activity.
You must meet one of the seven additional material participation work standards for EACH real estate rental property separately, unless you made a tax election to aggregate all your realty rental properties into a single realty rental business. This election must be made in a prior year you seek to deduct all your real estate rental loss, or in the year you first seek to deduct all your real estate rental loss. Proving one of the seven material participation work standards for each real estate property you own separately is much more difficult, if not impossible, than proving one of the seven material participation work standards for all your real estate rental properties combined. This election is made by attaching a written statement to your original federal income tax return, electing to treat all real estate rental properties as a single realty rental activity.  Failure to have made this election means a nightmare from hell evidence project having to prove one of seven material participation work standards for each real estate rental property separately.