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.
REPS Hours v. Material Participation Hours (Is There Such A Thing?)
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?
Education And Research Hours
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:
- The taxpayer was not compensated for services. Most individuals do not work significant hours without expecting wage or commissions.
- The taxpayer's residence is hundreds of miles from the activity.
- The taxpayer has a W-2 wage job requiring 40+ hours a week for which he or she receives significant compensation.
- The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
- There is paid on-site management/foreman/supervisor and/or employees who provide day-to-day oversight and care of the operations.
- The taxpayer is elderly or has health issues.
- The majority of the hours claimed are for work that does not materially impact operations.
- Business operations would continue uninterrupted if the taxpayer did not perform the services claimed.
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.
Can Education And Research Hours Ever Count?
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:
- checking messages for work orders,
- purchasing materials and cleaning supplies,
- supervising workers doing rehabilitation work,
- meeting with and conducting background checks on prospective tenants,
- executing leases,
- handling complaints regarding existing tenants,
- collecting rent payments from tenants,
- searching for new properties to purchase, and
- taking real estate classes for continuing education.
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:
- Studying and reviewing financial statements or reports on operations of the activity
- Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use
- Monitoring the finances or operations of the activity in a non-managerial capacity
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.
What Hours DO Count?
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:
- Hours spent acquiring property (not research hours!),
- Showing the property to prospective tenants,
- Writing and placing rental ads
- Taking tenant applications
- Running background checks and screening tenants
- Preparing and negotiating leases
- Cleaning the units after tenant move-out
- Maintaining the grounds
- Doing repairs yourself
- Doing improvements yourself or arranging (and managing, but not “watching”) others to do them
- Hiring and supervising a property manager
- Purchasing supplies and materials for use on the rentals
- Inspecting the property
- Communicating with tenants, responding to their complaints
- Collecting rents
- Evicting tenants
- Traveling to your rentals (as long as there is a business reason to do so)
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.