Are you a Real Estate Professional?

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Are you a “Real Estate” professional in the eyes of the IRS?

It does not matter if you are a bookkeeper, Enrolled Agent, CPA, Attorney or an employee of the IRS the tax code is daunting and easy to misinterpret.  Even if you understand it the application of the regulation presents a further complication.  An area in my tax practice where I see mistakes routinely made is in the application of the title “Real Estate Professional”, section 469 of the IRS code deals with this topic specifically. 

Recently I was contacted by a potential client.  The IRS had sent him a notice that they were going to audit him.  He retained me for representation during the audit.  Being defined as a real estate professional is very advantageous to the tax payer.  The biggest advantage is that the passive activity loss limitations no longer apply.  Also real estate professionals are able to exclude rental income from the additional 3.8% tax on net investment income.  This client, named Jed had 3 rental properties and ran a business doing construction/home repairs and improvements.  He self-prepared his taxes by hand.  Between him and his wife they had a joint MAGI income which was in excess of $150,000.  He had claimed on his return that he was in fact a “Real Estate” professional.  But in speaking with Jed he wasn’t sure what the definition of one was for sure.  I explained a real estate profession in the eyes of the IRS has two main requirements and they are;

  1. More than one-half of the taxpayer’s personal services must be performed in real property trades or businesses in which he materially participates; and
  2. The taxpayer must perform more than 750 hours of service in real property trades or the businesses in which he materially participates.

If both tests are met the taxpayer is allowed to deduct all of the loss for the rentals in which he materially participates.  Material participation is defined by Treasury Regulation

Section 1.469-5T;

  1. You participate in the activity for more than 500 hours during the year,
  2. Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
  3. Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than you,
  4. The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours.
  5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,
  6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
  7. A generic facts and circumstances test.

Most people who invest in rental property are not able to meet these stringent requirements.  In general passive income losses, which is what rental income is considered, are only allowed to offset passive gains.  The IRS gives a special allowance under section 469(i) allowing up to $25,000 of passive loss to be offset by earned income subject to income limitations and the requirement that the individual “Materially Participate”.  Should a taxpayer have more passive activity losses than they are able to offset in a given year those losses can be carried forward to future years.  In Jed's case he exceeded the allowable Modified Adjusted Gross Income amount of $150,000 disqualifying him from the $25,000 allowance provided by the IRS and was forced to use the “Real Estate” professional or carry forward the loss to a year where he might qualify to use it.

Luckily for Joe he met the two-part test required by the IRS to be considered a real estate professional.  In his primary profession of being a contractor he more than met the minimum time requirement.  Because he met the time requirement as a contractor this qualification extended over to his activities as a land lord.  Because he met the IRS requirements of the definition of a real estate professional he was then allowed to deduct the loss of his rental properties.  In Joe's case, he only had about an $8,000 loss for the year.  This loss ultimately saved him about $1,600 in the taxes he paid in 2016, as you can see the ability to meet the real estate professional definition of the IRS can be lucrative.

I represented Joe in front of the IRS for his audit.  The IRS auditor didn’t blink an eye when it came to Joe being considered a “Real Estate” professional.  I had Joe provide some simple documentation as to his hours, his activities and the auditor was satisfied with respect to the real estate professional definition. 

Scott Vance is a fee-only planner and Enrolled Agent at Taxvanta serving the Raleigh, N.C. area. He recently retired from the Army. His background allows him to uniquely understand issues faced by military personnel, but he works with all clients. He is currently a candidate for CFP® certification and seeks to provide objective, commission free advice to clients. Vance was born and raised in Pennsylvania. He is married to Amy. They have a son, Brandon. They enjoy skiing and kayaking. He can be reached by email at scott@taxvanta.com

Article Disclaimer: This article was written by a valued blog contributor but Triangle Real Estate Investors Association does not give legal, tax, economic, or investment advice. TREIA disclaims all liability for the action or inaction taken or not taken as a result of communications from or to its members, officers, directors, employees and contractors. Each person should consult their own counsel, accountant and other advisors as to legal, tax, economic, investment, and related matters concerning Real Estate and other investments.


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Forgotten depreciation deduction a major tax issue

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Real estate investing provides many tax benefits, and depreciation is one of the biggest. It’s also one of the more misunderstood.

Depreciation lets you deduct a portion of the cost of the investment each year for the length of its IRS-designated life span.  The depreciation computation is figured based on the value of the improvements, not on the land underneath the improvements.  This necessitates that you be able to determine the value of the land and the value of the improvements.  This determination is generally included in the multitude of closing documents you received when buying the property or found on the county real estate tax website.  It is essential that you keep your closing documents.  There are additional costs that can be expensed and loan costs that must be amortized involved in the closing itself.

A recent client case provides a good example for this deduction and how it can be forgotten.

Joe, an old Army buddy into my office asking for help with his taxes.  He had done his taxes up to this point as he had a pretty simple tax situation but about two years ago he moved and turned his old primary home into a rental property.  The first year of owning his home he had done his taxes and he had read some articles about depreciation and expenses that had gotten him thinking that maybe he had done something wrong on his taxes so the following year when his taxes were due he came to me make sure everything was correct. 

I reviewed his prior year tax return and immediately knew I was going to have to file an amendment to correct some glaring mistakes.  The first thing I looked at was his Schedule E.  He had about $10,000 of rental income and no expenses.  He had a 1099 showing interest and taxes for the property.  He had mistakenly included all the interest and taxes from the 1099 as an itemized expense and had not prorated the amounts between schedule A and E.  That was pretty simple.  When I computed his mistake, he had taken the standard deduction so the decreased itemized amount did not negatively affect him but I when I added up the interest and taxes attributable to the rental portion of of the property it reduced his income down to about $7,000.

Next I took a look at his depreciation.  Which was pretty quick because he hadn’t taken any.  IRS tax rules state that any depreciation recapture is computed on the amount that was take or the amount that should have been taken.  So, since the IRS requires the computation of depreciation recapture whether or not you actually took it, it makes sense to take the deduction when you can.  Figuring depreciation requires the computation of a basis of the property.  Generally, for someone buying a property as an investment property, their basis would be the purchase price of the improvements, not the land, minus buying costs plus amounts spent on capital improvements.  In the case of converting a primary property to a rental property this computation is a little more complicated.  It is the lesser of the adjusted basis or the fair market value at the time of conversion. 

In my friend’s case he had paid $250,000 for his home.  $50,000 of which was for land costs.  He also paid about $3,000 in closing costs and had made no capital improvements to the property.  This gave him a basis in the property of $197,000.  On the date he left the property and turned it into a rental it was estimated to be worth about $350,000 of which $300,000 was attributable to land value.  That $300,000 is divided by 330 to get a monthly depreciation amount of $909.  330 is the length of time in months the IRS says to depreciate residential real estate over.  The property had been turned into a rental for the last 5 months of the year.  This lead to a total cost of $4,545 that could be apportioned to depreciation, bringing his income from the rental property down to $2,455.

Then I talked with him some more.  He had paid rental property management fees of about $1,000, a homeowner’s fee is $600 and had other miscellaneous expense related to his property totaling $400.  All these expenses totaled about $2,000, leaving about $455 of income from the rental property.

I sat down and showed him all this.  Of course he asked me so what is the difference?  And so I laid it out for him.  Before I corrected his taxes he had a taxable income of of about $110,000 after his taxable income was about $100,000.  He was in the 28% tax bracket, by reducing his taxable income by the $10,000 we had reduced his prior year tax bill by about $2,800.  We filed an amended 1040X and got his money back.

Carefully accounting for costs when it comes to rental property and other deductions that you may be eligible for is key.  Knowing how those costs and deductions are computed and how to deduct them is essential in ensuring you make the most of your rental property.

Scott Vance is a fee-only planner and Enrolled Agent at Taxvanta serving the Raleigh, N.C. area. He recently retired from the Army. His background allows him to uniquely understand issues faced by military personnel, but he works with all clients. He is currently a candidate for CFP® certification and seeks to provide objective, commission free advice to clients. Vance was born and raised in Pennsylvania. He is married to Amy. They have a son, Brandon. They enjoy skiing and kayaking. He can be reached by email at scott@taxvanta.com

Article Disclaimer: This article was written by a valued blog contributor but Triangle Real Estate Investors Association does not give legal, tax, economic, or investment advice. TREIA disclaims all liability for the action or inaction taken or not taken as a result of communications from or to its members, officers, directors, employees and contractors. Each person should consult their own counsel, accountant and other advisors as to legal, tax, economic, investment, and related matters concerning Real Estate and other investments.  


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