IRS Audits for Real Estate Professionals

IRS Audits for Real Estate Professionals

As the year ends, it’s time to get things in order for your tax returns. A friend of ours owns rental properties was audited last year.  She shared some interesting items that you may find helpful:

“Nevadans (she lives in Nevada) are audited 150% more than people living in Wyoming.

In the 2010 JK Lasser Real Estate Investors Tax manual it states, more or less, (copyright laws):

If you show a lot of income besides the real estate income,  the IRS thinks you have a full time job and so they think you cannot spend more than half your time in your real estate business so they may select you for an audit.”

– My Note:  The real estate professional status is based on hours that are performed in real estate functions. You must spend more time in real estate activities than in any other activity for which you are compensated to claim real estate as your profession on your return and to get the tax advantages of working in a real estate business.

One of the biggest benefits to investing in real estate is the ability to offset the real estate paper losses (primarily caused by depreciation) against your other income. If you can qualify as a real estate professional, then 100% of your paper real estate losses may be used to offset your other income. –

The Internal Revenue Service is going after real estate professionals, so if you are claiming this status on your tax return, you need to be aware that the IRS is after you. They are now auditing a lot more real estate professionals and they are using their own rules to disqualify enough hours of your real estate professional activities so that you no longer qualify as a real estate professional.

The Internal Revenue Service is going over every hour of activity that taxpayers claim and then disallowing enough hours so that the taxpayer cannot meet either the 750-hour test or the one-half-time test.

There are certain items on your return that attract the attention of the IRS:

They look at the occupation line on the tax return (where you sign and it asks for your job description) to see if it states that you are in real estate.

If you have rental properties that are out of state and a property manager is used, they will check the Schedule E on your tax return to see if both the property management expense lines are completed, as well as to see where the property is located. The IRS is claiming that any time spent with property managers will not count toward real estate professional time since it shows them that you did not materially participate in the property. This is a good reason to hold your rental property in a separate entity; doing so will eliminate the Schedule E from your tax return (and instead will be reported on a separate tax return).

Large travel expenses are listed on Schedule E.

The Internal Revenue Service is making the argument that time spent looking for new property does not count toward your real estate professional time and instead is considered investment time..”

A qualified real estate activity is any thing in which you “develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease, or sell” real estate.  If you are claiming to be a real estate professional on your tax return, you must be able to substantiate 750 hours worked in this profession and show that this was more hours than you spent in any other business endeavor.

Be sure to keep good records, dates and receipts.

What can you share to help other investors with preparing their tax returns?

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46 Comments

  1. Hi Mike:

    This is a question for a CPA, preferably someone you use or a CPA who is a specialist in real estate. Sorry I’m not more help.

    Please let us know what you find out.

  2. Does the IRS always actively screen when someone puts down real estate professional status? This was the first time that mine and my wife’s combined AGI exceeded 100k significantly (our AGI this year was about 135k and we have always been able to claim losses on our rentals in the past with a lower AGI). I checked off the real estate salesperson designation on TaxAct not realizing that this was inappropriate as we both have full time jobs in the healthcare industry. Should I file an amended return at this point? Very concerned about this :-/

  3. Hi CHSMith:
    Either you don’t understand REP status or your company is not set up properly to take all the tax advantages that are offered by this status (and the benefits offered are many and large which is why it is so tough to be able to claim this status).

    In this conversation, you focus on your lack of loses, however the reason to qualify for REP status is to protect your profits. Finally, I believe you’re confused about the scrutiny for 1099 with employees rather than having them as w2 earners. No matter how you pay, you’d better be doing it correctly or you open yourself and your company up to all kinds of problems. However, this is a totally separate conversation and applies equally to you and your business whether you claim REP status or not.

    Thanks for adding to the conversation.

  4. BTW besides the above assertion of IRS auditing REPs a CPA gave a talk to our REIA and mentioned that claiming REP also increases your scrutiny of whether you 1099 your contractors. REP means you are held to a higher standard of running a company. Was the inference. No case law given.

    FWIW my view is that REP is not worth it for my landlording business even though my wife is retired during our self managing 34 rentals with 5 new rehabs per year. I don’t see the value in my return of greater taking of RE losses against ordinary income, least for me. Our 34 properties run at good profit, IE no losses. So why take on the possible higher audit risks of REP when It doesn’t benefit me at all.

    From the above it seems REP may benefit some with a small amount of ordinary income AND RE losses. When I had a high paying day job even then still no benefit becausee of the phase out of deducting losses as your income is over $100k or some staired tiers PLUS we ran at a profit so no losses to deduct regardless.

    I’m googling for how to rescind past claims of REP… :)

  5. Carol:
    A calendar app is a great idea! I used something similar for mileage when I used to claim that.

    Thank you so much for adding to the conversation.

  6. Last year I was audited for 2 prior years after claiming I was a real estate professional (of a group of properties.) The auditor confirmed they are targeting REP’s. It took weeks but I reconstructed my tasks based on ATM receipts for supplies (toilet flanges, paint, etc.) I just listed everything chronologically with descriptions, careful not to over claim hours for tasks.) I won REP in one year, lost the other because my income was too high in the lost year to successfully claim I spent over 50% on the properties that year.

    In the future, I would use a calendar app that allows you to make notes of what you do (when you do it) and even paste in pictures of the work. This makes it a concurrent business record and irreproachable.

  7. David, I am going through it right now. Have been for six months and still continuing. Its been crazy. I hired experienced firm in dealing with this. What I realize, it is complicated. I don’t understand your situation, however being a landlord does count. That is exactly who the REP is designed for. Your auditor is wrong, unless there is more to what you have shared here. (When my case started, I have spent hundreds of hours researching the REP rules and regulations, to understand what I was dealing with.)

  8. David:
    Don’t lose confidence. Keep track of your hours, make sure you spend more time in your real estate business than in your w2 business, and get a good real estate CPA who can guide you in which hours you can count and which you can’t. It’s actually quite simple – plenty of people claim the REP designation.

    Thanks for commenting here.

  9. Wow. I’m preparing to take REP designation for 2015 tax year and after reading this I’m starting to think again. How could an auditor say that a landlord cannot qualify as a REP!? How can they say that an owner doesn’t change a ******* toilet!? I’m really concerned about this.
    My wife and I own 7 rentals and I work FULL weeks to renovate the current project and I have one right behind it that will take a few months to complete. Total Rehabs. Half of the properties are inner city with section 8 tenants. Trust me those properties require much more time to manage than “normal” ones! I’m getting sick just thinking about this. I work 60 hrs a week doing these renovations, and to think the IRS can say I can’t change an outlet or a toilet is insane.

    Has anyone ever gone through an REP audit and not been robbed by the IRS? I’m losing confidence quickly…

  10. Hi Stan:
    I’ve heard others deny hours spent managing vacation rentals for Real Estate Professional hours.

    This is why you always need a good CPA who can back up deductions with IRS codes. If you can’t prove an auditor wrong, their decision stands.

    Good luck, and thanks for asking.

  11. I have 9 vacation properties I rent out. Three do not meet the long term requirement of above 7 day average rental. An audtor is stating I can claim them toward the 750 hours since I aggregated as one. However, is saying the time spent on them counts toward w2 hours instead of Realestate Professional hours in calculating the > than 50% rule.
    This means their time is being counted against the hours added for >50%. That seems incorrect to me, since they are part of a realestate activity of managing or operating realestate?
    If anyone has clarification, would be appreciated.

  12. I have no idea. Again, this is a question for your CPA.

    Please let us know what you find out!

  13. What I intended to ask is if an individual is a real estate professional it appears that you attach the election to aggregate your rental real estate properties in the first year that you qualify as a REP. The election is binding for future years. My question is if the election was made in the 1990s by a prior accountant and those records are not available to review and the taxpayer has treated all subsequent returns as the election affords, how do you prove the election was made? Do most REPs attach the election every year?

  14. Hi Suzanne:

    This is a question for your CPA. If I understand your question correctly, I think this issue is defined in your entity structuring. The Articles of Incorporation for your LLC should spell out what your business does which implies the tax structure. However, I am not an expert and don’t make any decisions based on my limited knowledge – seek out a professional CPA for tax advice. So much depends upon your CPAs handling of your tax returns and how your attorney structured your company.

    Thanks for asking.

  15. Does the aggregation election need to be made annually? The regulations hint that the answer is no. If you made the election in 1995 (and it is binding for subsequent years) and those tax returns are not accessible any more, how do you prove to the IRS that you made the election to treat all your RRE properties as one?

  16. Hi Kathy:
    You say you claimed Real Estate Professional status last year for a very specific reason. To claim that of course, you must meet all the necessary criteria like working at least 750 hours per year in the business, and that has to be more hours than you work in any other profession.

    If you have met all the requirements, your CPA should be able to tell you what will count toward your hours and what won’t. For one thing, the allowances can change every year. I had one friend tell me an auditor wouldn’t even let her claim the hours they spent looking for properties! If that is true, I doubt driving time would be allowed.

    Please let us know what you find out from your tax adviser and thanks for reading my post and asking!

  17. What a great site- thanks I claimed REP last year after our management company did nothing when a window blew out in 2012 Maine winter. here’s my question, does the 3 1/2 hour driving time count towards my hours?

  18. It is very confusing – unnecessarily so. Even the IRS and their auditors don’t know the “true” answers. So much depends upon interpretation.

    One of the HUGE problems is that Congress makes the IRS laws and they are not accountants or CPAs. Then the laws are turned over to the IRS for interpretation and enforcement. An impossible structure and we, the taxpayers, pay for the mess. If it was a simple process, the government would save $billions. I’m so sorry you’re caught in this mess and knowing your not alone does not help at all.

    Thank you for adding the great link.

  19. Hi Karen:
    That’s a great question but has to be asked of your CPA. There are some unknown moving parts in the question, plus the rules change annually and what’s true in 2014 may not have been true in 2011…. (which is why CPAs have job security).

    I would think you would not start again at zero, but be able to carry things from year to year, regardless of your status. And, I have also heard things like looking for properties does not count toward the hours. Probably an attempt to stop vacationers from tying to deduct a Hawaii vacation by saying “I was looking for properties there.”

    Best to you with your audit and please let us know how it turns out. Another problem with audits is it very much depends upon the auditor. What one will pass, another won’t. It is so important to have a great real estate CPA who stays aware of IRS regulations and codes.

    For future information, you might want to check out Diane Kennedy’s book “The Insider’s Guide to Real Estate Investing Loopholes”, or anything else she has dealing with what you’re going through. Good luck.

  20. Very informative article and comments. I’m in the middle of an REP audit for 2011 and 2012 but was audited for 2006 as well. In the 2006 audit, I WAS allowed REP status but this new auditor says that designation is determined on a yearly basis. Here’s my question: let’s say he finds I wasn’t a REP for 2011 but did put in the 750 hrs. in 2012. My net loss carryover is huge: would I have to start again at ZERO deductions if I wasn’t a REP for 2011, but was for 2012?

    Also, the auditor is adamant that overseeing others do the work and looking for properties does NOT qualify toward the 750 hrs. Anyone have authority otherwise?
    Thank you for your thoughts.

  21. Wow, Robert, what a story!

    Our attorneys (more than one, actually) have said to us that real estate investors actually go into court with the assumption of guilt and must prove their innocence. We do everything we can to avoid court because, even when you win, you loose… due to the emotional toil, the time wasted, and the tremendous expense involved.

    I’m so sorry you had such a terrible experience, but thanks for taking the time to share it.

    May all your troubles be behind you.

  22. II used to have a real estate license and listed and sold properties full time 30 years ago. Then I got an engineering degree and let my license expire. In my career as an engineer between jobs I bought and renovated residential properties.

    When my kids were college age my wife and I mortgaged our family home and invested in two student housing/vacation home properties near our children’s colleges and worked as landlords and property managers in addition to our day jobs. This experience has been frustrating, painful, time consuming and financially disastrous because of the housing bubble burst.
    When the taxes got too complicated for us we hired a company to prepare my taxes. I was audited for the 2009 taxes on the limited loss issue, because the IRS auditor thought it impossible that we could manage the properties ourselves. In efforts to improve and sell the properties we borrowed more money and invested my wife’s inheritance into the real estate hoping for the economy to turn around. Our goal was to recoup our second mortgage money and get out from underneath the debt by selling them both but the depressed real estate prices have made it impossible to date.

    The IRS dispute was about $3,000 of underpayment because we were not in their opinion by IRS definition “real estate professionals”. A few lawyers we interviewed wanted about $3,000 to “take the case.” My legal insurance from work was useless and would only cover $300. My accountant was not licensed to practice before tax court so he couldn’t do anything but testify on our behalf.

    I was scrambling to find representation and sick with the flue and worry while my accountant also had health and family problems when the court date was fast approaching. In the week prior to our scheduled appearance I called to ask the court to continue the case because of this situation and ended up on a phone conference “pro-se” with the prosecution team and the Tax Court judge.
    The pompous acting judge was willing to “not want sick people in his courtroom” but strongly advised us to settle the case before the court date because in his opinion, from what he could see, this might be a “frivolous case” and a waste of time. As such he could fine us $25,000 or more in addition to what we owe.

    After I thanked him for his opinion, we ended the phone meeting and I called the prosecutor. He actually seemed empathetic and agreed to waive the “penalty” assessment but had to “by law” charge the interest.
    The tax court is evidently prejudiced toward the IRS persecution of low income landlords (mom and pop real estate professionals.) Arguing the case would be fruitless and expensive and might incur the wrath of an annoyed judge’s fines.

    Bottom line: Justice is not likely in Tax court.

  23. Thanks, Greg!

    And as he said, Dean, always get your final ok from a good CPA.

    Let us know what you find out, please.

  24. In response to Dean’s question above, you can sometimes count hours you spend working in real estate for a company toward your personal hours if you own at least 5% of that company. The hours you spend for the company can be totally unrelated to your own properties. I’m not sure how it works if you are in independent contractor instead of an employee. But it might be possible, Dean, for you to count those hours if you bought a 5% interest in the company you are working for. Talk to a good CPA about this.

  25. Hi Kim:

    I’m so sorry for the nightmare you’re going through!

    You only need to prove 750 hours total working in the real estate business. And, it must be more hours than you work in any other job.

    I know these audits can go on and on. Yes, they can get crazy. I think you need better counsel and representation, neither of which I am qualified to give. You probably need a tax attorney, more than just a CPA.

    Please keep us posted on how this all plays out.

  26. Hello Karen, my husband and I are going thru the same nightmare as others have described. We have provided mounds of documentation to our auditor and have the wonderful help of our CPA whom we’ve used for over 20 years. He has indicated that he has never in his 49 years of doing business been to court but looks like we are headed that way. We have 8 units and its my full time job to manage them. We have provided logs of 1011 hours of time worked by myself and 180 hours of work from my husband. Of course, the auditor is picking it apart line by line. My question is since I have two bldgs (two 4-plex’s) do I have to prove 750 hrs total or more than1000 which shows 500 per bldg. my CPA is also confused by this as well. Another problem is every time we satisfy their questions they send us more to the point it’s getting silly. They just today asked for me to draw a template of the building. It’s a 4-plex for goodness sake!! We feel harassed and wonder if we have any recourse or can ask for a different auditor. She is from Eastern Europe and is very hard to understand and has gone back on verbal agreements several times. We talked with her supervisor and had a clear understanding with him of two more requirements they need to wrap this up only to receive three pages of additional requirements from her. Items not even discussed in our meeting. This has been going on for months and it seems to never end. We can’t trust anything she says for example when we had our initial meeting with her she gave us two weeks to submit all required info before she submitted her final report only to actually submit it 4 days later disallowing every single deduction for 2010 and 2012. She never even asked for info from 2010. Her final report says we owe approx $40k. I just need someone to help us with this nightmare and don’t know where to turn. Any help will be appreciated.
    Thank you, Kim

  27. Hi Dean:
    I am not a tax consultant! You must seek professional counsel to answer all legal questions.

    That being said, as I understand it, the 750 hours per year that you need for this status is time working on your own properties, not a job you are paid for. And, any losses you are/were entitled to should roll forward meaning you shouldn’t have lost the ability to use any losses that you have not yet claimed.

    Now, take your questions to a real estate knowledgeable CPA and/or tax adviser to get the TRUE answer to your questions then, please, let us know here what you find out!

    Thanks for your question and here’s wishing you tremendous real estate success!

  28. Hello Karen, Thanks for the informative article. I am looking to claim this status. I am a property manager for 2 apartment buildings which I am paid as an independent contractor and recieve a 1099. I spend the rest of my time on my 11 personally owned investment properties. Do you think my duties as a property manager will qualify even though I dont currently have my real estate license? Also, I have been doing this for over 5 years and have accumulated a lot of accrued losses, Do I have a chance to amend the past 3 years.

    Thanks – Dean

  29. Hi Michelle:

    I’m certainly no tax accountant, but my guess is “no” that would not count toward your hours.

    A good real estate CPA is the one to ask for guidance.

  30. Hi Karen, Thank you for the great article! Do you know by any chance if hours spent working as a notary signing agent count as real estate activity? I have looked all over the web and can’t find anything about closers.
    Thanks!
    Michelle

  31. Oh, my gosh, Vince. This isn’t possible. Are you planning to appeal it? Direct involvement in the management of your properties is exactly what qualifies as REP hours. This just can’t be right.

    Please keep us updated.

  32. I just had the same experience as Dougie, we own 9 properties and my wife manages them full time. IRS auditor told us today that it doesn’t matter how many properties you own, you cannot qualify as a REP as a landlord. Our CPA went through the audit with us and told us he’s never seen anything like it. The IRS has their own rules to discount almost every activity you could conceivably put on a log. Our auditor told us his final decision was to not accept our log of over 1,000 hrs and was unwilling to tell us which activities were acceptable and which were not. If you’re picked for an audit, you really do need to anticipate the worse, and do not expect the IRS’s subjective determination to actually make sense.

  33. Thanks, Kerry, for asking our CPA questions here.

  34. OH, no, Dougie! I hate to hear that! Do you use a CPA to file your taxes? I would think a good CPA could defend at least some of that time and the repairs that they’re taking from you. I can’t believe they’re bothering legitimate, hard working taxpayers when there are so many out there who are truly breaking the law that they could be pursuing.

    Thank you for sharing your story. I hope talking about it helps in some way.

  35. The IRS is using its own rules to negate the 750 hours. I own 12 rental properties, file as a real estate professional, and had two tax years audited over the last 11 month period. The IRS tore apart my logs, disallowing work hours for doing a number of repairs because they claimed that replacing a toilet wasn’t something typically done by an owner and replacing a bad light switch or outlet could only be done by a licensed electrician! They finally discounted the credibility of the logs because receipts for supplies were from stores located in a different state, but only 15 minutes from the rental properties! And then they threatened , “take us to tax court – you will never win there!” A bunch of thieves!

  36. Yes if a CPA or other preparer takes a position on a tax return that there is not reasonable support for they can be sanctioned by the IRS with anything from preparer penalties to having practice rights in from of the IRS taken away depending on the circumstances.

  37. Thanks, Kerry, for your comment!

    Absolutely no one should claim this status unless they truly qualify and are prepared to prove it with documentation. And, CPAs need to substantiate the accuracy before they file a return using this status.

    Aren’t you held somewhat responsible for filing an inaccurate claim for your client? With an audit, CPAs are called in to defend returns they’ve prepared, correct?

  38. I am a CPA and I can tell you that if you claim REP with one or two rentals you will lose on audit almost every time. The IRS is auditing this very heavily and for a very good reason, most people that claim it do not qualify for it.

  39. Fabulous idea, Kim! I hope you hear back from Lily soon.

    If you have other questions and needs going forward, never hesitate to ask them here!

  40. @Lily
    I’m a “soon to be” stay at home mom and my husband and I are planning on running a rental business as well. I’d love to talk with you and get your perspective on things wrt becoming an LLC, claiming REP for taxes, etc. Maybe we could even start a group via FB or something to share ideas, problems, etc. If you’re interested FB message me. Kim “Hust” Langley.

    Thanks! Look forward to hearing from you.

  41. Chip, I don’t know of any IRS document. Here’s what I’ve read and share. Other than this, be sure to ask your tax planner/CPA.

    “A qualified real estate activity is any thing in which you ‘develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease, or sell’ real estate. 

The key is that you perform personal services in these activities, but you don’t necessarily have to be the one performing the work. You can be supervising, meeting, planning–all of the activities that go into truly running a business.”

    Thanks for your question!

  42. Karen, is there a document from the IRS that defines the activities that are allowed when tracking hours to qualify for the REP designation?

  43. There are so many ways for the government to collect and/or save funds. I agree, going after hard working, contributing citizens seems like a ridiculous choice.

  44. Why not go after corporations and send foreign countries a bill for all the foreign aid instead if going after hard working american people? Country is circling the drain.

  45. Lily:

    Thanks for your question!

    I certainly can’t give tax info, though I’m perfectly comfortable sharing what I read.

    I suggest you (1) get a good CPA who is familiar with Real Estate Tax Law – not all CPA’s are.

    And, (2) read Diane Kennedy’s book The Insider’s Guide to Real Estate Investing Loopholes. Lots of great info there.

    I hope this helps. Let us know here what you find out!

  46. Hi Karen,

    You mentioned “The Internal Revenue Service is making the argument that time spent looking for new property does not count toward your real estate professional time and instead is considered investment time.”

    Does it mean that the time spent looking for properties BEFORE the purchase of my rental property can be counted toward the REP time?

    I hold my two local rental properties under a husband and wife 50/50 type of rental LLC. My husband has a full-time job. I’m a stay-at-mom, I run our rental business and log 750+ hours on REP time, no management company involved.

    If we report tax on Schedule E with REP status checked, will that increase the chance of IRS audit? You mentioned “This is a good reason to hold your rental property in a separate entity; doing so will eliminate the Schedule E from your tax return (and instead will be reported on a separate tax return).”. What is the other way we can report our tax? Do we need to file 1065? Should I split the loss 50/50 between me and my husband?

    I’ve been researching on IRS/REP issues. They are still very confusing to me. Can this time be counted toward my REP time at next year’s tax reporting?

    Hope you can shine some light. Thanks a lot!

    Regards,
    Lily

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