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The Real Estate Professional (REP) status is coveted in the world of real estate investors as it allows taxpayers to deduct an unlimited amount of passive losses against all other income. Without electing REP, a real estate investor is limited to deducting $25,000 of their passive losses assuming their income level hasn't otherwise phased them out from deducting passive losses at all.
The REP status is elusive – certain criteria must be met prior to electing and qualifying as a REP. That criteria has been discussed many times on our blog and podcast, but here's a reminder in case you've forgotten:
- Of all hours worked, more than 50% must be in a real estate trade or business.
- You must work at least 750 hours in a real estate trade or business.
- You must demonstrate "material participation" in your real estate trade or business.
This article will not explore the above three criteria specifically, but rather how many rentals you need to own in order to ensure you have a sure shot at successfully qualifying as a REP. One thing is for certain: do not elect REP on your own. As you're about to see, you can shoot yourself in the foot, or even miss a great opportunity to save on taxes.
A Tale of Two Real Estate Investors
In March 2018, two tax court cases were decided related to the REP status. In both court cases, the taxpayers had elected to be treated as a REP in order to deduct the passive losses against their income. The first taxpayer owned five rental properties totaling to eight units. The second taxpayer owned only two rental properties. One taxpayer successfully defending the REP status while the other did not. Of the two taxpayers, who do you think won?
The second taxpayer. Don't judge a book by it's cover.
Many investors think that quantity of rental properties is what will allow them to meet the three criteria listed earlier. However these two court cases decided in March show us that it's really the quality of hours that matters, not the quantity of rental properties.
Where the Taxpayer Owning Five Rentals Went Wrong
If you are one of our clients, you know how much we stress that you must keep a contemporaneous log of hours if you wish to elect REP status. Many investors think they they can just casually elect REP status and later reconstruct hour logs if they are ever audited. The case of Pourmirzaie v. Commissioner, TC Memo 2018-26 shows us just how futile poor record keeping can be.
The taxpayer in the case had five rental properties making up 8 total units. The rentals were located in California, Arizona, and Washington. Once the taxpayers were audited, they haphazardly attempted to put an hour log together based on memory. The hour logs exceeded the 750 hour and greater than half time requirements as well as material participation requirements. Though the court acknowledged the hours entered by the taxpayers, under closer scrutiny, it was revealed how poor the hour log actually was.
The court found the following issues with the taxpayer's calendars:
"The 2010 calendar has entries for every Saturday and Sunday in 2010 other than Sunday, October 31 (Halloween), and Saturday, December 25 (Christmas Day). The usual, uniform entry for both Saturday and Sunday is, without identifying a location (but we assume the San Jose property), “Weekly Cleaning and Repairing”, from 10 a.m. to 6 p.m. on Saturday and from 10 a.m. to 4 p.m. on Sunday. There are occasional entries for time spent in San Diego. There are twice a month entries for midweek “Security Surveillance”, uniformly from 8 to 10 p.m., and there are assorted other entries on various dates, such as “Home Depot”, “Paperwork and Bill Paying”, and “Post Office”, some lacking time entries and some, like “Paperwork and Bill Paying”, showing twice monthly time entries, usually from 7 to 8 p.m. The 2010 calendar does not specify who, as between Mr. or Mrs. Pourmirzaie, performed the listed tasks.
As you can see from the above, the taxpayers are insisting that they were working on the rentals every Saturday and Sunday, including on Halloween, for the exact same amount of time and without identifying which property they were working on. Sounds pretty sketchy right?
The court then examined the taxpayers' credit card and bank statements. As you can see from the court documents below, the taxpayers time log showed that they were working on their rentals, even though they were travelling overseas.
The 2011 calendar shows 2 hours of surveillance from 8 to 10 p.m. on April 27 and 3 hours on paperwork and bill paying from 7 to 10 p.m. on April 29. Monthly statements for petitioners’ checking account at Wells Fargo Bank for the months of April and May 2011 show check card purchases for food and lodging on April 28 and 29 in London, England, and at Heathrow airport. There are no domestic purchases shown for either of those dates. The 2011 calendar shows both petitioners working at an unspecified property from 10 a.m. until 4 p.m. on August 7. The Wells Fargo Bank statement for August 2011 shows food purchases in Dallas, Texas, on that date. The 2011 calendar shows one or both petitioners working at unspecified properties for 40 hours on September 9 through 13. The Wells Fargo Bank statement for September 2011 shows food and other purchases and a cash withdrawal in Philadelphia, Pennsylvania, on those dates. The 2011 calendar shows Mrs. Pourmirzaie working at an unspecified property on October 22 and 23. The Wells Fargo Bank statement for October shows food and other purchases in New York, New York, Boca Raton, Florida, and Philadelphia, Pennsylvania, on those dates.
The court went on to question the integrity of the hour log and eventually struck it down. The court decided that, though the taxpayers owned plenty of real estate and could have met the REP requirements, their hour logs could not confidently demonstrate meeting the 750 hour requirement. As a result, the taxpayers were not REPs and had to pay back-taxes and penalties.
How the Taxpayer Owning Only Two Rentals Qualified as a REP
In Franco v. Commissioner, TC Summary Opinion 2018-9, the court ultimately held that, even though the taxpayer only owned two rental properties, the taxpayer qualified as a REP. The key difference in this case is that the taxpayer kept a great log of his hours and was able to confidently demonstrate time worked.
The taxpayer in this case was an architect and owned his own business. Generally, that fact alone would disqualify a taxpayer from the REP status as the taxpayer would not be able to work "more than half their time" in real estate. However the taxpayer kept a time log of the architect hours worked, and during the year in question, the taxpayer only logged 649 architect hours. Because of this, the taxpayer could still meet the "greater than half your time" requirement for the REP status.
The taxpayer spent a lot of time at his rentals, specifically providing maintenance and repair services on a weekly basis. The tenants did not keep up with their own trash, so the taxpayer had to make weekly trips to keep the grounds clean and take the trash out.
Additionally, the taxpayer managed his own two properties, which meant coordinating move-outs with tenants, showings with prospects, utilities, and bill payments.
More importantly, when the court took a look at the taxpayer's bank and credit card statements, there were purchases made at home supply stores on the dates that the taxpayer recorded hours working on the properties.
The court concluded that the taxpayer was indeed a REP as indicated by the hour long that was substantiated by a solid paper trail. The court had confidence that the taxpayer developed the log as the events occurred rather than retroactively.
So How Many Rentals Do You Need to Be a Real Estate Professional?
As you can see from the above two court cases, it's not about how many rentals you have but rather what activities you perform and how long it takes. If you have a property manager managing your rentals, you need more, or larger, properties to qualify as a REP. If you are managing the rentals yourself, theoretically you only need one rental to qualify as a REP.
The major factor that could disqualify you is your day job (or gig). If you spend a significant amount of time working on your day job, you'll never meet the "greater than half your time" requirement to be a REP. Maybe you should pick up Tim Ferris' Four Hour Workweek to learn how to cut back those working hours!
Many of our clients qualify as REPs. From general partners in syndications to small-time landlords, you can create a fact pattern that provides for the REP classification. The results can be phenomenal and result in six figure tax savings if you structure your facts correctly.
Want to learn more about the Real Estate Professional (REP), check out to our podcast on the subject!