How the IRS Lost $55,000 in This IRS Rental Properties AuditTax Planning
I just returned from a very unsatisfactory visit with the IRS. The auditor examined my three rental properties, disallowed my losses, and told me to expect a tax bill for $55,000.
Current score: IRS $55,000 ahead.
One good thing happened, I think. The IRS agreed that my wife is a real estate professional.
The bad thing was that the IRS said my wife did not materially participate in the rentals, because the more than 750 hours shown in her logbook that count to make her a real estate professional include time that does not count as material participation, such as time spent
- inspecting, analyzing, choosing, and acquiring property;
- reviewing statements, reports, and publications;
- preparing summaries;
- doing computer analysis;
- making visits to the property without doing substantive work; and
- preparing the newly acquired property for rental.
With this, the IRS examiner said my wife passed as a real estate professional but failed to materially participate in the properties because she had less than 500 hours of material participation.
Our rental properties include
- a condo rented on a month-to-month lease,
- a single-family home rented on a month-to-month lease, and
- a vacation cabin rented on a one-week basis for 20 weeks a year.
We make no personal use of the rentals.
Can you help?
First, let’s start with the really good news. The IRS conceded that your wife was a real estate professional. That’s terrific, because that’s one tough hurdle for taxpayers who have no real estate activities other than their rentals.
With your wife as a tax-law-defined real estate professional, you can deduct your rental losses for each of the properties in which you materially participate against all your other income.
Had you made an election to put your properties in a group, then the material participation would have been determined for the group.
Here’s good news: The 500 hours are not relevant to your situation. That 500-hour rule is just one of seven possible material participation tests that you find in IRS Reg. Section 1.469-5T(a)(1).
So, your next hurdle is to look at the seven material participation tests on a property-by-property basis. Then, for each property, pick the one test of the seven that gives you material participation. If you can do this for each of the three properties, you keep your $55,000.
As we mentioned above, you have seven different possibilities for achieving material participation. For each individual property, you need to pass one of the seven tests to deduct your losses from that property. Let’s start with the condo.
Condo. To materially participate in the condo, your best possibility is the “more than 100 hours” test. This test requires that your participation be both more than 100 hours and not less than the participation by any other individual.
In Pohoski, the court stated that the taxpayer had to count only the time that front-desk personnel actually spent on his unit, not the total time that they manned the desk.4 You might need to use the Pohoski rationale to pass muster regarding material participation on your condo.
Single-family home. Since you do everything in connection with this rental, you pass material participation under the “substantially all” test.
Vacation cabin. Your wife does all the work for the vacation cabin, except for that done by a housekeeper who spends three to four hours for each of the 20 weeks that the vacation cabin is rented (say 3.5 x 20 weeks, for a total of about 70 hours of housekeeping). You mentioned that weeds grow through the mulch during the hot months so you pay a guy to pull the weeds.
For this vacation cabin, you and your wife can combine your hours of effort to pass the 100-hour test. Make the 100-hour test your first target for material participation on the vacation cabin. You want your combined efforts to exceed 100 hours and to match or exceed the housekeeper’s or weed puller’s time. For purposes of material participation, your wife’s participation includes your participation.
To assert that you are a real estate professional, either you or your wife individually has to pass the 750-hour test. The IRS said that your wife passed this test.
But for material participation on each of the properties, you and your wife may combine your time. Thus, the time you spend doing repairs and yard work on the vacation cabin count just as though that work were done by your wife alone.
The IRS is wrong in its disallowance of your investor time. You may count your investor time as material participation when you are directly involved in the day-to-day operations of the activity.
Your wife’s daily involvement with the vacation cabin certainly qualifies that cabin for this exception.
Your involvement with the single-family home where you have no outside management of any type certainly makes its investor time count as material participation.
You likely have to exclude from material participation any investor time you spent on the condo.
This answer gives you what you need for your next meeting with the IRS. Use this article as your presentation outline to make your points.
Print the footnotes as proof. They contain the relevant citations of the IRS regulations and the one court case.
Your goal in your second meeting with the IRS is to get the IRS to agree on what’s required for your material participation hours. The best way to get agreement is to show the IRS in its own regulations why your hours qualify for material participation.
You Are in Good Shape
You appear to have material participation nailed for the single-family rental and the vacation cabin hotel. This leaves only the condo. To win the condo, you may have to present the Pohoski case as part of your position.
Return on Investment
Your ability to deduct rental losses against all your other income means that the government helps subsidize your rental property results. Government subsidies increase the after-tax return on your investment.
You earn your government subsidies when you take the passive loss disallowance rules out of play, as the subscriber in this article did.
- The fact that the IRS examiner disallows your deductions does not mean they are not deductible.
- If you suffer disallowed deductions, do some homework and then reenter the game with knowledge.
- The first and toughest test of deducting your rentals is passing the real estate professional test.
- Being a real estate professional simply allows you to deduct losses on the properties in which you materially participate. Thus, there’s a two-step hurdle to deducting rental losses.
- When buying rentals, project your after-tax results.