I am now a full time real estate professional. The IRS defines “real estate professional” as someone who spends who spends more than half of his working hours in real estate and more than 750 hours a year tending to real-estate activities. This distinction is important because as a real estate professional you can fully deduct losses — including depreciation, interest expense on loans and property taxes. If you are not a real estate professional, you are considered a “passive investor”, and can only deduct a limited part of your losses. This is no small difference in status, as the IRS has identified income from rent and royalties as well as capital gains as areas of large under tax reporting. As a result, the tax returns of real estate professionals are being looked at more closely by the IRS and audited.
To the real estate professional, the criteria for professional status seems easy to meet. I along with other real estate professionals spend all our time on active real estate activities such as buying, selling, and developing investment properties. It is what I do for a living. I have no other job. For others such as real estate agents, or loan brokers, it would seem obvious that they are real estate professionals as well. However, this Wall Street Journal article points out that the IRS is targeting real estate professionals, and the burden of proof is on the real estate professional to prove their status. The article tells of a real estate broker and investor who is in an ongoing battle with the IRS to prove his status. Even though, this broker has been in the business for 20 years, and has a real estate portfolio of over $20 million dollars, the IRS is questioning his status. He has spent to date $20,000 in lawyer and accountant fees defending his status, and could spend as much as $100,000 before the battle with the IRS is over. At stake is several hundred thousand dollars in tax liabilities, fines, and interest, if it is determined that he is not a real estate professional, and prior year tax returns have to be adjusted.
Even if you have no doubt that your are a real estate professional, and you have been in the real estate business for many years, it is not a given that the IRS will see it that way. To protect your status, I suggest you do as I have started doing.
- Keep a daily log of your daily business activities such as meetings, phone calls, and research time. Make notes as how these activities relate to your business, such as networking function for business development.
- Keep records of projects that you are involved in. Detail your role in the project, the work you do, and the people you talk to regarding the project. If you travel for business, keep travel records and logs of your activities. Identify the purpose of your trip, and who you met with.
- If you take continuing education classes or seminars, record those and note the time spent and how it relates to your business.
It seems like a lot of additional documentation to prove something that seems obvious to us, but like everything with the IRS, the burden of proof is on us. If you are audited, you will be asked to provide this information anyways, so it is better to be prepared, or you could jeopardize the huge tax savings you have been enjoying as a real estate professional.
