An interesting tax court case from April 2022 shows you must be able to prove you spent enough time on your real estate activities if you want to qualify as a real estate professional.

Background of the Tax Court Case Sezonov, TC Memo 2022-40, 4/20/22

First, as a general rule, real estate investors can only take deductions of passive activity losses (PALs) up to the amount of their “passive income” for that tax year. (There are other limitations, but we’re sticking with PALs currently.) Therefore, real estate investors can’t usually claim annual losses except for the limited exception of “active participants .” As of the date of this posting, you can use up to $25K of losses to offset non-passive income with active participation. This $25K deduction is phased out for modified adjusted gross income between $100K and $150K. (See the IRS Tax Form 8582, Part II, for how and where this gets reported on your personal tax return.) 

Real Estate Professional Requirements (REPS)

Let’s say your real estate activities meet the IRS rules of being a real estate professional. Then, you can deduct a loss against non-passive income, similar to other ordinary businesses. However, you must meet two requirements to qualify as a real estate professional. 

1) More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate. 

2) You spend more than 750 hours on your real property trades or businesses. 

If you satisfy this two-part test from the IRS, then the real estate activities in which you materially participate aren’t considered passive activities. 

IRS Challenges a Taxpayer’s Real Estate Professional Status

In the case referenced above, the IRS challenged a taxpayer on whether he fulfilled the two REPS requirements in the years 2013 and 2014. In this case, the taxpayer was a resident in Ohio. He was the sole member of a limited liability company (LLC) through which he conducted a wholesale HVAC business. He was the only owner and ran the business solo – there were no employees. 

In 2013, the LLC purchased two long-term rental properties in Florida. The taxpayer and his spouse rented both of the properties during 2013 and 2014 while they remained out-of-state investors back in Ohio. 

The spouse advertised the Florida rental properties. She also communicated with renters and prospective renters by email. Between rentals, she would clean the property for the next renter or hire a cleaning service for the job. The taxpayer assisted in managing the property by responding to emails and performing maintenance and repairs while his spouse was responsible for the daily management activities. 

Unfortunately, the couple didn’t keep contemporaneous records of the hours they worked in their Florida rental properties, which is never a good idea. While their case was pending in the Tax Court, the taxpayer’s wife estimated the time they both worked on the rentals and created time logs for that. 

REPS Rejected

The IRS notified the taxpayer that the IRS was not going to allow them to deduct any of the loss from his Florida real estate rentals. The IRS assessed a significant deficiency in taxes paid. 

Recordkeeping Outcome

While the couple’s recordkeeping was terrible, it didn’t really matter. Even if the Tax Court accepted the logs, it noted that the hours did not total up anywhere close to 750 hours. As a result, the IRS denied the passive loss deductions. 

Lessons Learned

If you want to qualify as a real estate professional, you need to put in the time and be able to prove it. Be diligent; the IRS is always looking for ways to increase its tax revenues.