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News & Information: Orlando REALTOR® magazine - Special Feature

Heavy Mettle

Monday, March 25, 2013  
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Orlando REALTOR® | MarchApril 2013

The IRS is cracking down,
leaving real estate investors
to prove themselves worthy
of loss deductions

By Peter Pappas

As the housing market and the general recession continue to bite into REALTOR® income, those who also wear the "real estate investor” hat have increasingly turned to their tax preparers to find ways to get maximum tax benefit from losses. Predictably, the Internal Revenue Service has responded by increasingly upping audits on the tax returns of those claiming real estate loss deductions.

The IRS’s main area of audit focus is the distinction between passive real estate investors whose deductions are limited and active real estate investors who are allowed the full range of deductions. 

The distinction is not easy to make. To be considered an active investor under provisions of Section 469 of the Internal Revenue Code, an investor must: (1) be a "real estate professional” and (2) "materially participate” in the real estate operation. Only when an investor meets both of these standards will he be able to fully deduct his rental losses.

In order to be considered a "real estate professional,” the investor must have spent more than 750 hours during the year engaged in real estate activities and must have devoted more than 50 percent of his working hours to real estate tasks rather than tasks associated with his day job.

Generally, the IRS will require that the real estate investor prove his material participation by showing that he spent at least 500 hours working on each of his properties. However, someone who has elected to consolidate all of his rental operations and treat them as one activity will only have to show that he spent 500 hours working on all of the properties combined. The election, once made, continues indefinitely until it is revoked by the taxpayer.

Even though it is not mandated in the tax code, the IRS also requires detailed proof that a real estate investor is an active rather than a passive investor. This means that real estate investors must maintain contemporaneously created logs that provide hour-by-hour details of the time spent on specific real estate activities.

Because IRS auditors insist on this detailed contemporaneous schedule of hours, the real estate investor often is forced to challenge the active versus passive classification at the appeals level or in United States Tax Court. Real estate losses are a hot-button issue with the IRS, but real estate investors can and do often prevail in disputes involving the active versus passive nature of their activities.


Peter Pappas, the Pappas Group, is a tax attorney and a CPA. He can be reached at ppappas@pappaslaw.com.


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