Investing in real estate allows you to build wealth over time, create an income stream, and hedge against inflation all at once. On top of that, investing in real estate offers incredible tax benefits that other asset classes can’t compete with.
Real estate investors often don’t pay tax on the cash flow from their rentals. Sometimes they even create large tax losses from their rentals that are able to be used in offsetting their other income, such as W2 and business income.
How can a real estate investor create a large tax loss?
The answer is maximizing depreciation - a phantom expense meant to track the deterioration of your rental property over time.
You can accelerate depreciation by performing a cost segregation study which often results in being able to write off 15-30% of the acquisition price in the first year.
Imagine you have $200k of income and buy a $600k 6-unit property. A cost segregation study may allow you to deduct $150k in depreciation expense in the year of acquisition. This would create a large tax loss (notably different than an actual operating loss).
But can you use that tax loss?
Answering this question requires an understanding of IRC Sec. 469, how it works, and exceptions to the general rules.
The general rule under Sec. 469 is that all rental activities are considered “per se” passive.
Passive losses from rentals can only offset other passive income or gain on sale from passive activities. This limitation often results in thousands of dollars worth of suspended passive losses that are carried forward.
Qualifying as a real estate professional is an exception to this rule.
If you qualify as a real estate professional and materially participate in your rental activities, then you are able to claim the entire loss generated from your rental real estate activities as non-passive. In the above example, this will reduce your $200k of income and easily translate to a minimum $30k in tax savings.
Here’s the issue: qualifying as a real estate professional is tough.
We see many high-income earners fall into the trap of thinking they can simply acquire real estate and easily achieve REPS. High-income earners are very motivated to mitigate their taxes and they believe REPS is the simple answer to their problem. They sometimes work with uninformed tax preparers and take unintentionally risky positions on their tax returns (REPS is a highly litigated area of the tax code).
When we go through the requirements of how one can realistically claim and substantiate REPS, we are often asked “Is there not an easier way? That sounds like a ton of work and it’s not what I originally learned from X [book/blog/class/tax advisor].”
Again, qualifying as a real estate professional is tough. And it’s not an area of the Code you should try to game.
We’re reminded of the saying “pigs get fat, hogs get slaughtered.”
We’ve seen so much misinformation floating around the web that we decided to develop this 12,000 word guide to set the record straight. This guide will explore the real estate professional status inside and out, including history, regulations, IRS Audit tricks, and court cases.
Though this guide is thorough, it has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction or using any information in this guide for tax planning purposes.
To understand the intent behind real estate professional status, we have to start with a short history lesson.
Prior to 1986, it was a phenomenal time to be a high-income earner and landlord. Taxpayers could deduct losses related to their rental real estate activities in full against their other income regardless of their level of participation. This allowed high-income earners to shelter their wages and business income with non-economic losses from real estate.
A physician, for example, could earn $800k in their W2 job or private practice, buy a few rentals, and accelerate their depreciation. This would create large tax losses that would offset or even eliminate their $800k of income.
Of course, wealthy people receiving tax breaks is always a hotly contested issue in the United States and Congress stepped in to plug the loophole.
The Tax Reform Act of 1986 added IRC Section 469 which eliminated this tax shelter for landlords. IRC Section 469 limits the taxpayer’s ability to deduct losses from businesses in which he or she does not materially participate and also from rental activities.
As a result, a taxpayer could only use passive losses generated from rental activities to offset the taxpayer’s passive income (IRC Sec. 469(d)(1)). This dealt a huge blow to high-income earners who subsequently saw a sharp rise in their tax liabilities.
While IRC Section 469 curbed the passive loss tax shelter for the rich, it unintentionally punished taxpayers running real estate businesses. For example, a builder could construct a handful of properties, sell some and keep the others as rentals, but could no longer write the rental losses off against the income from the sales.
This was, of course, unfair. A physician who has two offices, one generating a large amount of income and another generating a loss, could use the losses from one to offset the income on the other.
Yet a builder who was in real estate full-time was unable to use losses from his rental real estate activities to offset his income from his other real estate activities.
Recognizing this issue of inequity, Congress took action.
Beginning in 1994, IRC Section 469(c)(7) was added to the Code. This section allows a taxpayer qualifying as a real estate professional to deduct all rental real estate losses regardless of how high their Modified Adjusted Gross Income might be.
The House committee report provided the following explanation for the change:
The committee considers it unfair that a person who performs personal services in a real estate trade or business in which he materially participates may not offset losses from rental real estate activities against income from non-rental real estate activities or against other types of income such as portfolio investment income. (H.R. Rep't No. 103-111, 103d Cong., 1st Sess. at 612-613 (May 25, 1993))
We’ll discuss the intricacies of IRC Section 469(c)(7) shortly but it’s important to note that the intent of adding this section was to allow taxpayers who are primarily participating in real estate activities to deduct losses.
It was not added as a way to game the tax system, though that’s the approach that many high-income earners now take.
The passive loss rules in IRC Section 469 limit a taxpayer’s ability to claim losses from a passive activity. As you’ll see below, rental real estate is considered a passive activity and there are three exceptions to the “per se” rules.
IRC Section 469 defines a passive activity as:
Thanks to the second point, all rentals are considered passive by default. Passive rental losses can only offset net passive income or gain on sale from other passive activities (IRC Sec. 469(b)). Excess passive losses are suspended and carried forward.
Obviously, this treatment is not ideal for real estate investors.
To maximize tax benefits, we want to recharacterize our passive losses as “non-passive.” Non-passive losses can offset a taxpayer’s other income, including W2, business, and investment income without limit.
To recharacterize rental losses as non-passive, you must qualify for one of three exceptions to the passive activity rules. These exceptions give savvy real estate investors a way out of the passive loss trap and will allow them to use rental losses in full in the current tax year.
There are three key exceptions to getting around the default rule that all rental activities are passive:
The rest of this article will dive into the intricacies of qualifying as a real estate professional. Though it’s challenging to qualify as and substantiate real estate professional status, the juice is worth the squeeze.
Short-term rentals are a misunderstood and confusing area of the Code. You’ve likely heard of many different interpretations from qualified tax professionals and internet bloggers.
While we’re not going to dive into all the details here, it’s important to highlight how short-term rentals interact with real estate professional status.
First, Treas. Reg. Sec. 1.469-1T(e)(3)(ii)(A) provides an exception that states an activity is not a Section 469 rental activity if the average period of customer use for the property is seven days or less.
This means most AirBnB and VRBO properties are not considered “rental activities” under Section 469 of the code. This also means that you don’t need to qualify as a real estate professional under IRC Sec. 469(c)(7)(B) to claim your losses from a short-term rental activity as non-passive. You just need to demonstrate that you materially participated in the short-term rental activity and your losses will be non-passive.
So for those of you with full-time jobs or business roles, if you can’t qualify as a real estate professional, investing in short-term rentals could provide you an avenue to deducting rental losses as non-passive.
But don’t make the mistake of counting your short-term rental hours toward real estate professional status or you’ll end up like Todd and Pamela Bailey (hint: not a place you want to be) Todd and Pamela Bailey v. Commissioner, T.C. Summary Opinion 2011-22.
If you don’t have to qualify as a real estate professional to claim your short-term rental losses as non-passive, you don’t also get to count your short-term rental hours toward real estate professional status. This was also confirmed in Eger v. United States, USDC Northern District California, Case No. 18-cv-00199-DMR.
Again, if your short-term rental is excluded from the definition of a rental activity under Section 469, then you don’t need to qualify as a real estate professional to take the losses. But you also don’t get to count the participation hours on your short-term rental toward REPS.
Last major point: owning a short-term rental doesn’t necessarily mean that you automatically have a Schedule C business activity subject to self-employment tax. If you don’t provide substantial services to your tenant (while they are occupying your short-term rental), you likely have a Schedule E activity.
Best of both worlds right? A Schedule E rental that is non-passive while working a full-time job. Not bad.
As mentioned, the real estate professional status is an exception to the passive activity loss rules. It puts you on the path to characterizing your rental losses as non-passive which is the ideal treatment for real estate investors.
“Puts you on the path” - did you catch that?
Qualifying as a real estate professional means absolutely nothing in and of itself. A real estate professional merely overcomes the presumption that the rental activities are “per se” passive.
To achieve the non-passive characterization for your losses, you must also demonstrate that you materially participated in the rental activities, which is a separate set of tests. We’ll talk about material participation shortly.
To qualify as a real estate professional, a taxpayer must meet the following two criteria (IRC Sec. 469(c)(7)(B):
In the case of a married couple filing jointly, one spouse must achieve both #1 and #2 on their own, meaning spouses cannot combine service hours for the purposes of achieving real estate professional status.
There are a few important takeaways right off the bat.
The first is that in order to qualify as a real estate professional you must be participating in a real property trade or business.
The second takeaway is that you must perform personal service hours and materially participate. Personal service hours generally mean hours spent managing the day-to-day operations of the rental. Material participation means significant and continuous participation in the activity (discussed further later).
We have seen examples in the past of investors who think they need 500 hours of material participation and 250 hours of “anything else” but this is not the case.
You need 750 hours of personal service hours in a real property trade or business in which you materially participate. All 750 hours must be “material participation” hours. It’s just that 500 of those hours, if that’s the material participation test you’re pursuing, must specifically be spent on rental activities.
For example, I can spend 500 hours on my rentals and 250 hours brokering real estate deals. I qualify as a real estate professional in this case. I cannot spend 500 hours on my rentals and 250 hours on education and research and have a chance of substantiating my real estate professional status.
The third key takeaway is that it will be difficult to qualify for real estate professional status if you work a part-time job and nearly impossible to qualify if you work a full-time job.
Up next, we explore these key takeaways in depth and support our thoughts with Tax Court rulings and Code citations.
As discussed in the previous section, you need to spend 750 hours and more than half your time of personal service hours in a real property trade or business in which you materially participate.
What is a real property trade or business?
As provided by IRC Sec. 469(c)(7)(C), there are 11 real property trades or businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
If you are a serial entrepreneur and involved in multiple real property trades or businesses, you may group them for purposes of calculating the hours to meet the statutory tests described in IRC Sec. 469(c)(7)(B).
This means that you can be a real estate agent, a builder, and a property manager and count your aggregate personal service hours toward the “750” and “more than half your time” tests. This grouping election is supported by Miller v. Commissioner, T.C. Memo. 2011-219 and CCA 201427016 but it should not be confused with the -9 election to group your rentals for purposes of material participation.
Though the Regulations provide a baseline for what constitutes a real property trade or business, we have to look to Tax Court cases and Chief Counsel Advice (CCA) rulings for further guidance. For example, what does “brokerage” mean? Is that a real estate broker or a mortgage broker?
In CCA 201504010 the IRS ruled that a mortgage broker was not engaged in a real property trade or business. The main reason for this determination was that a mortgage broker simply puts together lenders and borrowers, a service that is indirectly related to real estate.
It seems then that the IRS’s position is that services that count toward real estate professional status must be directly related to the real property trade or business in question. Services that won’t count are those indirectly related to such a trade or business.
As an example, while our CPA firm works solely in the real estate space and saves clients boatloads in taxes, our staff won’t qualify as real estate professionals because we’re providing tax services not real property services.
Along those lines, in Calvanico v. Commissioner, T.C. Summ. 2015-64, the Tax Court and IRS agreed that the taxpayer, who was a licensed real estate appraiser performing appraisal work for an accounting firm, may be engaged in a real property trade or business. The taxpayer ultimately lost the case as they did not own at least 5% of their employer (IRC Sec. 469(c)(7)(D)) and therefore could not include any of the service time in their capacity as an employee.
But on the flip side, we have a case where an attorney was able to qualify as a real estate professional.
In Stanley v. United States (W.D. Ark. 11/12/15), the taxpayer owned a management company that managed his own rentals. He also provided legal services to his management company. The IRS argued that the legal services could not count toward real estate professional status but the Court disagreed. The Court held that the legal services did count toward real estate professional status because Section 469 does not specify the character of services performed to a real property trade or business, it just says services must be performed in a real property trade or business in which a taxpayer materially participates.
Theoretically then, as long as you own at least 5% of a real property trade or business, your time spent in that business will count toward real estate professional status regardless of your role in the company. Interesting indeed...
It’s also important to point out that you don't technically need a professional license in order for the Tax Court to consider you being in a real property trade or business.
In Agarwal v. Commissioner, T.C. Summ. 2009-29 the Tax Court held that a real estate agent was considered to be engaged in a real property trade or business. The IRS attempted to argue that a real estate agent was not a licensed “broker” and thus could not be involved in a brokerage real property trade or business. The Court sided with the taxpayer after reviewing the Webster definition of the term “brokerage” which is great news for real estate agents!
To summarize this section succinctly, if you own a 5% equity stake in a real property trade or business, any service hours you perform may be considered real estate professional hours. If you provide services to the real estate industry (tax, law, money lending) then you may not be able to use those service hours toward real estate professional status.
Recall from our two REPS statutory tests: for purposes of real estate professional status, you may only count personal service hours in real property trades or businesses in which you materially participate.
This means you need to identify all of the real property trades or businesses that you participate in. You then need to determine if you materially participate in these trades or businesses as you can only count hours related to those businesses in which you materially participate.
But remember, while materially participating in any real property trade or business may qualify you as a real estate professional, it doesn’t mean your rental losses are non-passive. To achieve the non-passive characterization, you must also demonstrate that you materially participate in your rental activities (Perez v. Commissioner, T.C. Memo 2010-232).
Let’s run through a couple of examples.
Kal Drogo brokers the real estate that he captures when raiding cities (Game of Thrones reference for those of you who haven’t watched the greatest show on earth… exclusive of the last season). Drogo materially participates in his brokering activities and spends 1100 hours on his transactions during the year. Drogo doesn’t work a separate job or business. As a result, Drogo qualifies as a real estate professional.
Drogo also has rentals that produce losses. Unfortunately, Drogo does not spend much time on his rentals and as a result he fails to materially participate. Because Drogo does not materially participate, his rental losses remain passive even though Drogo clearly qualifies as a real estate professional.
Across the Narrow Sea, John Snow is a property manager for Castle Black (another Game of Thrones reference for those not catching on). He spends 300 hours managing the property during the year. Separately, Snow has a rental portfolio that he manages himself, without a property manager. He spends 500 hours on his own rentals.
In this case, Snow gets to combine his two real property trades for purposes of real estate professional status and is able to show an aggregate of 800 hours. He qualifies as a real estate professional as a result. Snow has also materially participated in his rental activities which now means his rental losses are non-passive and can be written off against his other income.
If you take nothing else away from this article, just remember that you must qualify as a real estate professional and also show that you materially participated in your rental activities.
How do we figure out if we materially participated in our real property trades or businesses and rental activities?
At a high level, you must be involved in the operations of the activity on a regular, continuous, and substantial basis (IRC Sec. 469(h)(1)).
In an effort to define this further, the Regs. offer seven tests to demonstrate material participation (Temp. Reg. Sec. 1.469-5T(a)(1)). You must only meet one test and you must own a 5% stake in the employer for your hours to count. The first three are the tests our clients most often meet:
If you have a management company that maintains your rentals and collects rent, you’re going to have a tougher time demonstrating material participation. This is because test #2 is now unachievable (the property manager is performing substantially all of the activity) and #3 will be tough to substantiate.
If you don’t have a management company, you may be able to meet test #2 on the basis that you’ve performed substantially all of the participation in the activity. We’ll talk more about hours that count and don’t count in the next section.
Though a married couple filing jointly cannot combine hours for the purposes of the real estate professional tests, they can combine hours for purposes of material participation (IRC Sec. 469(h)(5)). This means one spouse can qualify as a real estate professional on their own and can then combine the non-real estate professional spouse’s material participation hours in rental activities to qualify jointly for material participation.
If you are a limited partner in a real estate trade or business, you may only establish material participation in that activity by meeting #1, #5, or #6 of the above tests. Keep this rule in mind if you’re expecting to group in LP stakes in syndicates to claim the losses the syndicates are promising you.
Major trap: without making a grouping election, you must materially participate in each rental activity separately.
To get around this issue, we can group all rental activities into one. We then just need to demonstrate material participation in the aggregate.
The grouping election is found in Regs. Sec. 1.469-9 and requires a formal election statement to be attached to your tax return in the year of making the election. This will group all rentals into one activity for purposes of Section 469. The election is binding for all future years and all future rental activities are automatically added to the group.
Proceed with caution though. This grouping election can create problems if you have suspended passive losses. When you sell a property in a group of properties, you may not have disposed of “substantially all” of the activity which will limit your ability to claim losses upon sale.
Let’s get one issue out of the way: qualifying as a real estate professional will be next to impossible for anyone working a full-time job. We’re not saying it’s 100% impossible, it’s next to impossible. We haven’t seen a Tax Court case where a taxpayer successfully substantiated real estate professional status while working a full-time job.
In a Tax Court case Penley, et ux. v. Commissioner, T.C. Memo 2017-65, the taxpayer under scrutiny had worked a full-time job and claimed real estate professional status during the year in question. The full-time job amounted to 2,194 hours and the taxpayer produced a time log showing they spent an additional 2,520 hours on real estate during the year.
Let’s do the math: 2,194 W2 hours + 2,520 REPS hours = 4,714 hours during the year. This translates to 90 hour weeks and 13 hour days assuming absolutely no vacation or sick days.
If you’re laughing along, so are we. It’s not impossible to work 13 hour days 365 days a year, but it’s certainly next to impossible.
The Tax Court didn’t buy it. They claimed Penley’s time log wasn’t realistic and represented more of a ball-park guesstimate than a contemporaneous log.
Another case, Hassanipour v. Commissioner, T.C. Memo. 2013-88, featured a taxpayer who worked full-time as a research associate and submitted weekly timesheets to his employer totalling 1,936 hours for the year.
The taxpayer in this case owned 28 rental units and a 50% stake in a Lake Tahoe property. He claimed on a time log submitted to the Court that he worked 1,182 hours on his real estate. He also submitted a statement that he spent an additional 650-800 hours on his real estate that he never recorded on his time log.
Again, the Tax Court didn’t bite. They noted that the taxpayer’s calendar was a 2008 calendar copyrighted for 2009… proof that the calendar was built retroactively. Additionally, the taxpayer’s credibility was questioned because he told the Tax Court that he only worked 1,610 hours for the year for his employer… lying to the Tax Court or lying to your employer? Either way, not a good look.
A separate case that seemed more realistic for taxpayers was Escalante v. Commissioner, T.C. Summ. 2015-47. The taxpayer in this case was a teacher who owned several rental properties.
Though school teachers generally get summers off, the taxpayer’s “employer” hours only reflected opening to closing bells during the school year. It did not reflect any additional time spent grading papers, attending meetings, or after school activities.
The taxpayer was found to have grossly understated their employer hours while simultaneously grossly overstating rental participation hours by sometimes recording more than 24 hours in one day. The Tax Court sided with the IRS.
If you are working a part-time job, or if your “full-time” job translates to a more part-time schedule, you have a shot at working your W2 job and qualifying as a real estate professional at the same time.
In Windham v. Commissioner, T.C. Memo 2017-68, the taxpayer was a part-time stock broker and contended that she qualified as a real estate professional. She managed all aspects of her 12 properties including finding tenants, collecting rent, coordinating with repairment, maintaining insurance, maintaining services and upkeep, and maintained records detailing all of her activity. During 2010, she withdrew $180k from her retirement account to pay for rental expenses which further proved her commitment to her rental portfolio.
The Tax Court sided with the taxpayer citing her substantial time spent on rental activities and her great records. More on great records in a minute.
In another case, Miller v. Commissioner, T.C. Memo. 2011-219, the taxpayer was a boat pilot “full-time” and contended that he worked more on his rentals than he did as a boat pilot. Though he was employed full-time, he worked less than 1,000 hours as a boat pilot. His time logs were kept contemporaneously and appeared to be credible.
Further, witnesses testified on the taxpayer’s behalf on the taxpayer’s incredible work ethic and bolstered his credibility. The Tax Court sided with the taxpayer and allowed real estate professional status.
So working a job and qualifying as a real estate professional at the same time can be done. You need to keep impeccable records and may require character witnesses to attest to your incredible work ethic. Otherwise, the IRS and Tax Court won’t buy your story. It’s all about how credible you seem.
That leads us to recordkeeping. You must keep records detailing your daily activities. Time logs, notes, emails, receipts, calendar appointments, credit card/bank transactions… it all needs to tie out and tell a compelling story.
This is especially true for anyone working a W2 job or running a business who is also claiming real estate professional status. You’ll need to demonstrate that you work more in real estate than your job and the only way to do that is to create a daily time log, full of detailed notes, that prove your credibility when challenged in Tax Court.
If you are claiming real estate professional status without keeping a time log, you’re in for a world of hurt.
You technically only need one rental property to qualify as a real estate professional and materially participate in a rental activity. Let’s rewind back to review our two statutory tests under IRC Sec. 469(c)(7)(B):
There’s nothing in these tests about how many properties you must own to achieve REPS and demonstrate material participation in your rental activity. It only takes one property.
And we’ll prove it.
In Smith v. Commissioner, T.C. Summary Opinion 2014-112, the taxpayer was a 63-year old disabled veteran. He had no other job due to being disabled and made himself available 24/7 to take care of his one three-unit property.
He handled all repairs and maintenance, visited the property each morning to curb the homeless population and make sure the grounds were clean of trash, and would take all trash bins out on Wednesday evenings and bring them back on Thursday mornings. He was the property manager and corresponded with tenants and collected their rent checks.
The Court agreed that he qualified as a real estate professional even though he only had one property.
Four things Smith had going for him in his Court case, though not made explicitly clear by the Tax Court:
Let’s look at a different case, Franco v. Commissioner, T.C. Summary Opinion 2018-9. In this case, the taxpayer owned two rental properties. He was also an architect and ran a small architecture business.
His time log for his architecture business showed he worked 649 hours for the year which translates to a very part-time non-rental activity. His time log for his one three-unit property showed that he had spent more than 750 hours on the rental activity.
The Court upheld the taxpayer’s real estate professional election, acknowledging that because his tenants did not maintain the property, it required the taxpayer to make weekly trips to inspect the property, make repairs, and take out the trash. The taxpayer also self-managed the property and had to deal with turnover and rent collections.
Sounds pretty similar to the Smith case.
But don’t get your hopes up too much. The next case is one where the taxpayer lost with one property and a part-time job.
In Flores v. Commissioner, T.C. Memo 2015-9, the taxpayer spent 1,295 hours working at a pavement striping business and had to overcome these hours to meet the second statutory test for real estate professional status. The taxpayer had one rental property and even though the taxpayer did everything himself, his time log showed only 799 hours.
The taxpayer contended that he had a second calendar that showed the additional hours needed however the Tax Court did not find the testimony credible.
The issue, in this case, was that the taxpayer couldn’t show he spent more time in real estate than his 1,295 hour day job. His time log and testimony weren’t found to be credible. Though the taxpayer may have felt that his rental activity was definitely not passive, what a taxpayer feels and what constitutes tax law are often very different results.
It’s also important to show you what’s in the IRS Passive Activity Loss Audit Technique Guide. This Guide documents the IRS’s position and gives you insight into how they will challenge your position on real estate professional status and material participation in your rental activities.
Specifically in the Guide:
Indicators that the taxpayer did not materially participate:
You’ll see we highlighted a handful of bullet points above. We believe these will be the biggest points of contention for landlords with small portfolios.
How will you substantiate your position knowing that the IRS is honing in on these issues?
This section is the apex of the entire article. In fact, you may have skipped directly to this section without reading the prior sections first because you’re so excited to start recording hours.
First, slow down. Go back and read all of the prior sections of this article. It’s critical that you obtain a fundamental understanding of REPS and that you build trust in that we know what the heck we’re talking about.
Second, understand that this is not an area of the Code that you want to play games with. You should not be thinking about “aiming” for REPS. You should be thinking about legitimately stepping into the shoes of a real estate professional and owning the role. The former lose audits and Tax Court cases while the latter win.
We want you to win.
This is going to get complicated, but here’s a simple litmus test to keep you out of trouble: if the day-to-day operations of your real property trade or business and your rentals would be unaffected by the hours you are claiming on your time log, then those logged hours don’t count.
Let’s get into specifics.
All hours logged must be personal service hours spent in a real property trade or business in which you materially participate. REPS hours and material participation hours are one in the same.
Many real estate investors erroneously believe that they need to show 500 hours of material participation and then log 250 hours of “anything else” to achieve real estate professional status. However, this is not how it works.
The statutory tests for real estate professional status found in IRC Sec. 469(c)(7)(B) state that in order to qualify as a real estate professional, a taxpayer must meet the “personal service” hour requirements in “real property trades or businesses in which the taxpayer materially participates.”
The “personal service” wording paired with “material participation” means that all of your logged hours must be personal service hours in real property trades or businesses in which you materially participate.
Said in another way: hours logged that are not personal service hours, or those spent in a non-material participation capacity, will not count.
So you cannot log 500 service hours for a rental activity that you materially participate in and then log a random 250 hours of anything else. The additional 250 hours still have to be personal service hours spent in a material participation capacity.
To back this up, we point to Temp. Regs. Sec. 1.469-5T(f)(2)(i)(B) which states that: One of the principal purposes for the performance of such work is to avoid the disallowance, under section 469 and the regulations thereunder, of any loss or credit from such activity.
Translation: if you are logging hours simply to avoid the passive activity loss rules, those hours won’t count as participation.
When you log 250 hours of “anything else,” how will you substantiate that the logged hours were personal service hours, in a material participation capacity?
How will you further provide that these hours weren’t recorded simply to avoid the passive loss limitations?
Another hotly debated topic for real estate professional status is whether or not education and research hours count. It makes sense that investors want to log education and research hours because (1) these hours can amount to a lot of time; and (2) they are easy to obtain.
When you review the IRS Passive Activity Loss Audit Technique Guide and a few hundred Tax Court cases, you’ll come to the same conclusion we have: sometimes small amounts of education and research hours count, but most of the time they don’t.
The issue is overcoming the hurdle of education and research hours being characterized as “investor” hours.
A Tax Court case that most supports the fact that education and research hours won’t count is Jafarpour v. Commissioner, T.C. Memo 2012-165. The taxpayer in the case recorded a significant amount of time researching properties and attending classes and seminars on real estate investing. The Court held:
Most of petitioners' real estate activities in 2006 consisted of researching potential investment properties throughout the United States. [...] ongoing involvement would consist mainly of approving rent prices and tenants. [...] we are not persuaded that Ms. Prang spent more than one-half of her personal services in a real estate trade or business during 2006.
The issue at play was that education and research hours are not “personal service” hours that are required to continue operating real estate rentals.
In the Tax Court case Padilla v. Commissioner, T.C. Summary Opinion 2015-38, the taxpayer argued that he spent more time in real estate than anywhere else however his time log was found to be made up primarily of investor hours.
The Court specifically found that “Most of the hours for each month were in the following generic categories: research properties near properties already owned; refinance research; foreclosure research (which appears to be considering properties that could be purchased); and researching new businesses…. They were not activities involving the taxpayer in the operation of his existing rental real estate activity, such as finding tenants, making or overseeing repairs, etc.”
The Court also noted that the taxpayer logged these hours in an attempt to hit 750 hours because he had hired a management company to manage his rentals and had little personal involvement.
Again, the Court is looking for activities involving the taxpayer in the day-to-day operation of the rentals, of which education and research are not.
We also have Levitz v. Commissioner, T.C. Summary Opinion 2018-10, where the taxpayer deducted “$35,000 to $40,000” worth of travel and education expenses to study various real estate markets, meet people in the field, attend seminars, and pass the CCIM exam. The Tax Court found that these activities were not considered material participation activities in a real property trade or business and were instead incurred with the intent to develop a career in real estate, a factor that weighed heavily against the taxpayers.
The IRS will almost certainly take the position that your education and research hours do not count as participation. This is evidenced by the IRS Passive Activity Loss Audit Technique Guide. Here is that excerpt again on material participation:
Indicators that the taxpayer did not materially participate:
We bolded three of these bulleted points for emphasis.
It will be tough for you to substantiate that without your education and research hours, the renters would have stopped paying rents, bills would no longer be paid, and repairs and maintenance would have gone awry.
It’s just not a feasible argument to make.
Theoretically, if your education and research hours directly impact the day-to-day operations of your business, they can be included as participation hours.
In Hailstock v. Commissioner, T.C. Memo 2016-146, the taxpayer owned numerous properties, didn't have outside employment, worked over 40 hours per week on stated properties, and used substantial amounts of her own resources to further her business.
Per the court case, Hailstock's duties included:
The Tax Court didn’t comment on whether searching for new properties or taking real estate classes were participation hours. However, we feel it’s safe to say that because the taxpayer was running his rental business full-time and participating in a significant manner, the education and research hours likely qualified as participation hours. Additionally, the “education” hours the taxpayer logged were to maintain his real estate license… an important variable to see continuity in a real estate agent’s business.
Another way to think about education and research hours is: if you are legitimately a real estate professional, your substantial participation in your real property trade or business will get you over the 750-hour threshold alone. If education and research hours are a major factor of whether you meet the 750 hours and more than half your time tests, you’re skating on very thin ice.
Remember what Temp. Regs. Sec. 1.469-5T(f)(2)(i)(B) says: [hours that don’t count are those] of the principal purposes for the performance of such work is to avoid the disallowance, under section 469 and the regulations thereunder, of any loss or credit from such activity.
This means that if you are logging hours simply to avoid the passive activity loss rules, those hours won’t count as participation.
Time spent in the capacity of an investor will not count as participation in the activity unless the taxpayer is directly involved in the day-to-day management or operations of the activity (Temp. Regs. Sec. 1.469-5T(f)(2)(ii)).
Specific investor-related activities include:
Other activities that may be deemed investor activities include organizing records, preparing taxes, paying bills, education, and research hours (W.A. Barniskis, 78 T.C. Memo 226, December 53,486(M), TC Memo 1999-258), (Padilla v. Commissioner, T.C. Summary Opinion 2015-38), (Jafarpour v. Commissioner, T.C. Memo 2012-165).
Hours spent “watching” contractors or “on-call” are not considered participation hours. This was detailed in Hairston v. Commissioner, T.C. Memo 2019-104. You must be actually performing services in order for your time to count as participation.
In Walter A. Barniskis, et ux., v. Commissioner, T.C. Memo 1999-258, the petitioner was denied material participation because his hours consisted primarily of organizing their personal records, preparing their taxes, paying bills, and reviewing their monthly statements of the rentals of their unit. The Court ruled that all of these constitute investor activities. Combined with the fact that the petitioner had a professional management firm working on the property, it was determined that he had passive activity losses which are not deductible.
The IRS’s position is that travel time does not count as participation hours in a real property trade or business. As detailed by the IRS Audit Technique Guide:
Travel Time generally should not be considered in computing the hourly tests for material participation, particularly if other factors indicate the taxpayer is not participating in the activity on a regular, continuous and substantial basis.( We have no express statutory guidance on travel. While not precedent setting and just a summary opinion, the following case provides guidance on travel time: Thomas E. Truskowsky, T.C. Summary Opinion 2003-130). Legislative history provides that "services must be integral to operations". It is somewhat difficult to construe that travel constitutes "services" or "participation" as contemplated by Congress or the Regulations. More importantly, travel is not integral to operations in most cases.
The Tax Court doesn’t necessarily agree however. In Leyh v. Commissioner, T.C. Summ. 2015-27 the taxpayer recorded only 632.5 hours on her time log but explained during audit that she had failed to record the time spent traveling among her 12 rental properties. The IRS countered that her log was inclusive of travel time, but based on her testimony at trial, the Court found that she had not included travel time in the time log.
After adding the travel time claimed by the taxpayer to the hours from her daily log, the total hours exceeded 750 and the Tax Court confirmed that the taxpayer qualified as a real estate professional.
There has been a lot of “don’ts” in this section so far. But let’s switch gears and talk about the hours that do count.
As a reminder, you can only count participation hours in real property trades or businesses in which you materially participate.
To materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis (IRC Sec. 469(h)(1)).
Participation hours in real property trades or businesses in which you materially participate are those that affect the day-to-day operations of the business.
For landlords, that can mean:
If you’re reading this list and thinking “crap I basically have to self-manage my rentals” you’re pretty much correct.
Qualifying as a real estate professional is not easy and anyone who tells you it is should probably not be giving tax advice.
It’s now a great time to remind you of our simple litmus test to keep you out of trouble: if the day-to-day operations of your real property trade or business and your rentals would be unaffected by the hours you are claiming on your time log, then those logged hours don’t count.
Let’s assume you get audited for something random and your real estate professional election gets scoped in. The burden of proof is on you, the taxpayer, to show that the IRS’s notice of deficiency is erroneous.
You will shift the burden of proof back to the IRS if you comply with substantiation requirements, maintain all records, and cooperate with the IRS about information, documents, meetings, witnesses, and interviews.
This is why we require all of our clients, regardless of whether they are primarily involved in real estate or not, to maintain contemporaneous time logs or a daily calendar. We’d rather be in a position where we shift the burden of proof back to the IRS than the other way around.
Though you don’t technically need to maintain this log daily, the Tax Court has previously held that the IRS is not required to accept a ballpark guesstimate of your hours (Hill v. Commissioner, T.C. Memo. 2010-200, aff'd, 436 Fed. Appx. 410 (5th Cir. 2011)). The Tax Court will also not accept ballpark guesstimates and undated notes estimating hours spent working on rentals (Gragg v. United States, Case No. 14-16053, CA9).
So keep the daily time log!
Temporary Regulations Section 1.469-5T(f)(4) states that:
If real estate is not your sole gig, you also need to keep a time log detailing how much time you spend in your non-real estate activities. This is critical to meet the “more than half” your time test to qualify as a real estate professional.
In Merino v. Commissioner, T.C. Memo. 2013-167, the taxpayer elected real estate professional status but failed to document how much time he spent in his two non-real estate businesses. As a result, he lost his case.
In Vandegrift v. Commissioner, T.C. Memo. 2012-14, the taxpayer was a salesman and also claimed real estate professional status. Unfortunately, he did not maintain records detailing how much time his salesperson job demanded and he also lost his case.
Keep great records of your real estate activities and non-real estate activities. This will shift the burden of proof to the IRS and you’ll have a much easier time under audit.
Not only is it important to log both your real estate professional hours and any hours spent in non-real estate activities, but it’s also critical to be a credible witness to your own time log.
If you read through real estate professional Tax Court cases, you’ll find that a common word used in issuing opinions is “credible.” The Court will have you and other witnesses testify. If you are able to recall extensive details about your activities, you will appear more credible than not (for example Zarrinnegar, et al v. Commissioner, T.C. Memo 2017-34).
Consider this scenario that we see all the time: one spouse is the full-time wage earner and also extremely interested in using real estate to protect and expand wealth. The other spouse stays at home with the kids and isn’t particularly interested in real estate. Regardless, they build a portfolio and claim real estate professional status for the stay-at-home spouse.
If the stay-at-home spouse doesn’t actually participate in the rental activities, how credible will they be when they testify in Tax Court?
In Escalante v. Commissioner, T.C. Summary Opinion 2015-47, the Court held that the taxpayer’s time log was not credible. It listed hundreds of hours for writing checks and reviewing mortgage statements. The Court explained in their determination that the Court does not exist in a vacuum and they must consider how long it would take them to write their own checks based on their own experience of daily life. Additionally, the taxpayer listed a 25-hour day in their time log which was obviously impossible.
In Hairston v. Commissioner, T.C. Memo 2019-104, the Court found that the taxpayer inflated his time log and did not grant real estate professional status. All tasks, no matter how trivial, took at least one hour to perform per the time log. Additionally, the taxpayer logged 93-105 hours of snow removal in a single year as well as 73 hours “watching” contractors perform their work.
In Pourmirzaie v. Commissioner, T.C. Memo 2018-26, the taxpayer did not maintain a time log and reconstructed it when audited. Though the taxpayer owned five rentals and 9 units, the Court held that the taxpayer did not qualify as a real estate professional because there were several issues with her time log.
One notable issue was that her time log showed her being at the rentals every single Saturday from 10am to 4pm performing “weekly cleaning and repairing” work. The bigger issue for the Court was that the taxpayer’s bank and credit card statements showed purchases in London, England and many other domestic areas, presumably incurred while traveling, while the time log indicated that the taxpayer was actually at the rentals performing services.
In Penley v. Commissioner, T.C. Memo 2017‑65, the taxpayer alleged that they worked 13 hour days between their full-time job and their rental real estate activities. This totaled 2,520 hours on real estate activities in addition to the taxpayer’s 2,195 day job hours. The Court found the time log to be greatly exaggerated and that working 4,600+ hours during one year is nearly impossible.
In Lee v. Commissioner, T.C. Memo. 2006-193, the taxpayer’s time log showed spending 24 hours to replace blinds, 56 hours to replace a toilet, and over 280 hours to close year-end books. The time entries were found to be unrealistic and not credible.
And then we have Birdsong v. Commissioner, T.C. Memo 2018-148, where the taxpayers failed to keep contemporaneous records but testified credibly to their activities and were able to substantiate REPS. From the Court ruling:
So while we highly recommend maintaining a daily time log, it’s not the end of the world if you can credibly testify in Court. In Birdsong, even though the taxpayers won, they were warned that they must begin keeping a contemporaneous time log as required by the regulations.
Let’s now discuss how an IRS agent will audit your real estate professional election. Knowing the process and what they will look at can help you piece together your case and substantiate your REPS election.
In our experience, real estate professional audits can sweep across a CPA’s client group.
For example, a CPA is playing loose and fast and claims REPS for clients even though they can’t possibly win because they are logging large amounts of non-participation (education and research, investor hours, etc.) hours to meet the 750 hour test. An IRS auditor reviews one client’s file, denies REPS, and then pulls three more clients from that CPA’s group. If none of them qualify as REPS, guess what happens next? All clients can get pulled for an audit.
Unbelievable? We have personal experience helping clients from a CPA firm where this exact scenario played out.
It’s absolutely critical that you work with a CPA who confidently tells you what you need to hear, not what you want to hear, about qualifying and substantiating real estate professional status.
Let’s talk about IRS audit execution.
The IRS is going to first attempt to determine whether any of your rentals are excluded from the definition of a rental activity under IRC Sec. 469. If real estate activities are excluded from the definition of a rental activity under IRC Sec. 469, then the hours of participation for that activity won’t count toward REPS.
This means hours logged on most AirBnB and vacation properties, which are generally excluded from the definition of a rental property under IRC Sec. 469, will not count as real estate professional hours.
Once the IRS has bucketed your rentals between those that are excluded from the definition of a rental activity and those that are included, they will begin analyzing your participation in your rentals. Any rentals under a third party property manager will be heavily scrutinized.
Here’s an excerpt from the Audit Technique Guide:
A taxpayer, who does most of the work in a rental, meets Test 2 for material participation in Reg. § 1.469-5T(a)(2). However, if there is on-site management, it may be difficult for the taxpayer to materially participate because:
Here’s how they will examine your participation:
Here’s the suggested interview questions the IRS provides an auditor:
750 HOUR TEST
Time does not count for purposes of the 750 hour test and the half personal services test – unless the taxpayer materially participates in the activity. One spouse ALONE must meet the 750 hour test.
MATERIAL PARTICIPATION IN THE RENTALS
They will also review whether or not you made the grouping election for material participation purposes (Treas. Regs. Sec. 1.469-9(g)) to treat all rental activities as one activity. Without this grouping election, a taxpayer must materially participate in each rental activity separately.
To examine the grouping election, here’s what you can expect from the auditor:
Qualifying and substantiating real estate professional status starts with understanding how an auditor will assess your situation. Review the above, especially the questions, and build support today that answer the questions.
Throughout the guidance and the questions the IRS provides to auditors, you’ll notice they believe rental activities don’t require much time to manage.
How will you overcome this presumption? How will you prove that you spent a significant amount of time managing and attending to your rentals?
The IRS does not play around with real estate professional status. It’s one of the most litigated pieces of the Tax Code. Get it right and you won’t be sorry later.
If you’ve read the entire article, you’ve probably picked up on some key misunderstandings and mistakes that we consistently see. We’ve provided a summary list below for your reading pleasure.
It’s 750 hours of personal service in a real property trade or business in which you materially participate. There’s no such thing as spending 500 hours of material participation hours on your rentals and an additional 250 hours of anything else. The statutory tests for IRC Sec. 469(c)(7)(B) clearly states that all 750 hours must be personal service hours in a real property trade or business in which you materially participate.
Don’t rely on education and research hours. These hours are not considered “personal service” hours. Additionally, it will be quite tough to argue that these hours were integral to the continued operation of your rentals. More than likely, your rentals will continue operating just fine without your education and research hours. Temp. Regs. Sec. 1.469-5T(f)(2)(i)(B) states that hours logged with the primary purpose of achieving REPS hours don’t count. You must be participating in the ongoing operations of your real property trade or business for hours to count.
If married, one spouse must hit the REPS tests on their own. For purposes of the statutory tests for real estate professional status, one spouse must achieve the required hours completely on their own.
But spouses can combine material participation hours. Though one spouse must hit the hour tests completely on their own for purposes of REPS, spouses may combine hours for purposes of demonstrating material participation in their rentals. This is great for situations where one spouse is a real estate agent and the other spouse manages the rentals.
Meeting the REPS tests but failing to materially participate in your rental activities. Working 750 hours and more than half your time in a real property trade or business means nothing for your rental losses. You must also show you materially participated in your rentals.
Failing to make the -9 election. If you forget to make the aggregation election under Regs. Sec. 1.469-9, then you must materially participate in each rental property separately. This will be difficult to do.
Having a full-time non-real estate job. You must work in a real property trade or business more than you work anywhere else. If you spend 2,100 hours in your full-time job, you must spend an additional 2,101 hours on real estate. Assuming that you can actually sustain working 11.5 hour days with no holidays, vacations, or sick days, it doesn’t matter because the IRS and Tax Court will never believe you. Over the 20+ years REPS has been litigated, not one taxpayer with a full-time job has been able to convince the Tax Court they qualified as a real estate professional.
Having a part-time non-real estate job and keeping bad records. If you have a part-time job, or run a business part-time, you can qualify for REPS. There’s plenty of case law to support that fact. However, you must keep incredibly detailed and organized records. You must document the time spent at your part-time job/business and also every minute spent on the real estate side. This is not for the lazy or faint of heart.
Failing to keep a record, on a contemporaneous basis, of time spent in real estate. You must keep detailed time logs of the time you spend in real estate. If you fail to do this, you can bet on losing if your case goes to Tax Court. Simply put: ballpark estimates are not accepted and the IRS will do anything they can to make you appear not credible in front of the Court. Keep good records and jot down detailed notes on a daily basis. If you take the stand seven years from now, you’ll want the ability to recall facts in great detail.
Holy smokes that was a lot of information. Let’s summarize the key points.
You must spend 750 personal service hours and more than half your time in real property trades or businesses in which you materially participate. There are 11 real property trades or businesses defined.
You must also show that you materially participated in your rental activities by meeting one of the seven tests. Without material participation, qualifying as a real estate professional means nothing.
For married couples, one spouse must qualify on his/her own for REPS but spouses may combine hours for purposes of meeting the material participation requirements. Oh and don’t forget to make the -9 election, otherwise you have to materially participate in each rental activity separately.
It’s nearly impossible to qualify for REPS with a full-time job. If you scale back to part-time, you’ll still find it tough but it’s doable. Just make sure you are actually participating because if you hire a property manager you’re most likely only contributing “investor” hours which don’t count as participation. And don’t try to pad your hours with education and research… the Tax Court won’t buy it.
You ultimately bear the burden of proof. You must maintain a time log on an ongoing basis with detailed notes of the facts. This will help you look credible when audited and taken to Tax Court.
Plan to be audited. This is a highly litigated piece of the Code. The IRS has specific beliefs and questions regarding REPS. They will come after you hard and your best defense is great documentation.
Lastly, this is not an area that you want to venture in alone or without proper guidance. Our team of real estate CPAs is amazing and we love Section 469.