This is the fourth and final episode in the REPS series. This episode is about IRS Audits of REPS! What is their perspective and lens they're looking through? What are they looking to see? How do you protect yourself? We discuss all of this in REPS 04.
As we've established, REPS is a highly litigated area of the tax code. It's important to understand how your opponent will come in and try and rip apart your story. If you haven't listened to the first three episodes in this series, we suggest you check those out first.
The IRS Audit Technique Guide is guidance that is given by the IRS to IRS auditors. It's their structural framework for conducting an audit. They include the relevant steps and questions.
"People typically lose real estate professional IRS audits for 1 of 3 reasons. 1) Poor record keeping 2) Logging time that isn't material participation time 3) Unable to corroborate and substantiate their participation in the rental activity."
IRS Audit Technique Guide
Here are some assumptions from the guide:
- Rental activities, by nature, usually do not require significant day-to-day involvement
- For any taxpayers using outside property management, the only material participation test available is the 500-hour test
- In many circumstances, an individual rental activity will not require 500 hours of material participation
- Will the taxpayer have sufficient time available to spend at least 50 hours on each rental activity?
The guide also mentions the massive incentive for taxpayers to claim real estate professional status. The guide specifically warns about manipulated time logs.
What steps will the auditor take?
1) Review your situation entirely and fully understand all of your income streams and activities
At a minimum, this includes your W2, Schedule C, and Schedule E.
2) Scrutinize your real estate situation
What are your real property trades or businesses? Where do you materially participate? Is you or your spouse the real estate professional?
In this step, they will request documentation of your timekeeping and closely examine your log.
They will scrutinize all activities you're involved in. Even if they aren't real estate, and even if you aren't getting paid. They are about actual hours spent in all activities because this is relevant to the material participation tests.
"I have this time log in front of me. Could you have possibly worked all of this time in real estate, based on all of your other activities?"
3) They will interview you.
They will ask questions about your personal life, business, civic activities, philanthropy, family obligations, and hobbies.
Be mindful that they're building a case around all of your time spent in all activities to determine the remaining time available for real estate.
They are going to assess your credibility.
4) They will give you a determination. At this point, you can decide if you want to contest or accept this determination. Most of these determinations go against the taxpayers. The determination is always detailed on the time log and types of hours logged.
List of indicators that the taxpayer did not materially participate:
- The taxpayer was not compensated for services
- The taxpayer's residence is hundreds of miles away from the rentals
- The taxpayer has a W2 wage requiring 40+ hours per week
- There is paid on-site management
- The taxpayer is elderly or has health issues
- The majority of hours claimed do not materially impact operations
- Business operations would continue uninterrupted if the taxpayer did not do the activities they logged
IRS Auditor Interview
"One of the first questions they're going to ask you is to describe the work you perform as a real estate professional."
They are going to try and gain clarity about all jobs you perform, including your W2. They will also look to determine who the real estate professional, you or your spouse. They will ask for the % of the real property trade or business that you own. If you own 5% or less, this time does not count. For example, if you work for a property management company as a W2 employee, you aren't a real estate professional unless you own 5% or more of the property management business.
"They're trying to build a case, they're trying to understand: do you actually spend what you say you spend in the rental real estate activity? If you're keeping a time log, it should say the date, hours spent, services, performed, which property, and detailed notes of the activity. Your entries of notes need to be specific and unique to that day."
"This is not an easy thing to achieve. If you want to achieve this, you really have to take it seriously. At the end of the day, it's a business that you're running. If you want real estate to be passive and hands-off, then that's what it will be - a passive activity."
If you're not a real estate professional, it's a better use of your time to embrace this fact and pursue other ways to generate tax-free cash flow.
"There are ways to create passive income and then use the rental passive losses to offset that passive income. Many of our clients are not real estate professionals, yet they have a portfolio that creates enormous cash flow, and they don't pay tax on the cash flow. That's the Warren Buffet approach: over time, I'm going to generate cash flow that I don't pay tax on because everything offsets, so my effective tax rate on my total income goes down."
For our next podcast series, Brandon and Thomas will dig into short-term rentals. Short-term rentals have exploded on the real estate scene lately, many of our clients are taking advantage of the short-term rental loophole. Yes, a loophole! Unlike REPS, there are characteristics of short-term rentals that could be considered a loophole!