Tax Lawyer's Blog

Beause of the housing crisis and the general recession it’s almost impossible to find a real estate investor who actually turned a profit in the last three years. Naturally, these investors are turning to their tax preparers to find ways to get the maximum tax benefit of their losses.

But the IRS is ready says tax lawyer and WebCPA guess blogger Philip Garrett Panitz:

The IRS is conducting a sweep of real estate investors that challenges deductions investors have been taking as a routine part of business for years. The sweep is based on an IRS belief that there is a “compliance gap” in this area.

The main area of focus is the distinction between passive investors whose deductions are limited and active investors who are allowed the full range of deductions:

But what constitutes a passive investor? The answer is easier to explain in the reverse (i.e., who is an active investor?) To be considered an active investor under provisions of Section 469, your client must: (1) be a “real estate professional” and (2) “materially participate” in the real estate operation. If your client meets both standards, then he may pass into the land of tax-reducing bliss.

But wait. The definition of “real estate professional” is not what it seems. Under the IRC, real estate professionals are individuals who spend more than 750 hours annually working on real estate, and devote more than 50 percent of working hours to real estate tasks rather than their day jobs.

But the inquiry isn’t over:

Assume your client meets the first standard. Now, he must meet the second. An IRS auditor will likely say that to qualify as a material participator, an investor must spend at least 500 hours working on each of his properties. This statement is not exactly true.

Let’s assume you made an election pursuant to Section 469(c)(7)  on a tax return, allowing properties to be lumped together to determine material participation. Your client can show that time spent collectively on properties totals 500 hours. This avoids having to show 500 hours on individual properties. The election, once made, continues indefinitely until you revoke it.

Of course, proving active participation is a problem for most taxpayers:

Unfortunately, the IRS takes the position that if investors don’t have objective proof of their working hours; they can’t count them. What does the IRS consider objective proof? A contemporaneously created log that provides minute-by-minute details of time spent on individual activities. Is this required under the Tax Code? No. Is the IRS insisting upon it to give credit for the time spent? Yes.

Panitz says that because IRS auditors and appeals officers often erroneously insist on a detailed contemporaneous schedule of hours the taxpayer worked on real estate activities during the year, the taxpayer may have no choice but to challenge the active/passive classification in Tax Court:

If your client goes to Tax Court, the judge will assess the credibility of your client and other witnesses. An electrician can testify that your client contacted him to do work, not some management company.

Although clients are loath to bring other people into litigation, it is necessary to prove objectivity. And from a practical standpoint, who will the IRS call as a witness to refute testimony from your client and witnesses? Unless your client has a bitter ex-partner, the answer is nobody. Nor will the IRS get your client to crack under vigorous cross-examination.

Going after real estate investors seems like piling on to me. Instead of intensified IRS scrutiny of the tax returns of real estate investors, perhaps we should consider relaxing the passive activity loss rules to allow real estate investors to recoup some of their losses by way of tax offsets.

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