A highly audited issue that often leads to US Tax Court litigation is whether or not real estate losses can be deducted as ordinary losses rather than having to classify the loss as passive. The disallowance of the passive activity loss has been such a hot tax controversy that it was listed among the Taxpayer Advocate’s “Most Litigated Issues” in its 2014 Annual Report to Congress. Therefore, it is worth paying extra special attention to reporting real estate losses when preparing and filing your 2014 taxes.
Real Estate Tax Controversy Background
As part of its anti-tax shelter agenda in 1986, Congress codified IRC 469. Generally speaking, IRC 469 precludes deducting passive activity losses from trade or business activities in which you do not materially participate. The tax code considers rental activities to be a passive activity.
To circumvent the passive activity classification you must meet the definition of a “real estate professional.” To meet the definition of a “real estate professional,” IRC 469(c)(7)(B) requires the following:
- More than one-half of your personal services performed during the year must be in real property trades or businesses in which he “materially participated”; and
- You must perform more than 750 hours of service during the taxable year in real property trades or business in which your materially participate.
Real property trades or businesses that qualify for the 750 hours of service are: development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage. This year, the IRS lawyers, Office of Chief Counsel, concluded that a mortgage broker is not engaged in a real property trade or business.
IRC 469(h) defines “martial participation” as regular, continuous, and substantial. In a tax audit, the IRS auditor is trained to look at seven tests listed in Reg. § 1.469-5T in making a determination of whether you materially participate. You will only need to pass one test for the auditor to determine that you materially participated. For example, if you work more than 500 hours during the year on one property, then the auditor or IRS lawyer will consider that you materially participated. You can make an election to group properties together to avoid having to work 500 hours on each property.
If you cannot fit under the “real estate professional” definition, then in order to circumvent the passive activity loss restriction, you must be “active participant” in the rental property business. The standard for an “active participant”, defined under IRC 469(i), is more lenient than “material participation” standard and requires you must own at least a 10% interest by value. If you are an “active participant,” then you are allowed to deduct up to $25,000 of losses; however, the allowable deduction gets phased depending on your filing status and modified adjusted gross income.
Net Investment Income (IRC 1411)
In 2013 and beyond, Congress began assessing a 3.8% tax to individuals, estates and trusts that have net investment income exceeding modified adjusted gross income thresholds. The thresholds are as follows:
- $250,000 for married filing jointly
- $125,000 for married filing separately
- $200,000 for head of household and single
Gross income derived from a trade or business that is passive is assessed with the 3.8% surtax. In order to avoid the surtax, you must squeeze into Reg. § 1.1411-4(g)(6) which excludes rental income from property used in a trade or business activity in which you materially participate. Therefore, real estate professionals can avoid the Net Investment Income Tax.
Audits and Tax Litigation
Real estate audits can be difficult because of the record retention requirements. Although the tax regulations, §1.469-5T (f)(4), state that contemporaneous daily time logs are not required if you can prove your material participation by any reasonable means, the Courts have held otherwise. The US Tax Court has held that “ball-park guesstimates” are insufficient to prove the hours claimed by the taxpayer. Therefore, it is paramount that you keep a diary memorializing the time spent on real estate activities. If not, you could be in an uphill battle if you are selected for audit.
Despite a reduced budget, the IRS is adept at examining returns that are claiming real estate losses. If the IRS is denying your rental property losses or your having problems locating your tax records, then the Law Offices of Todd S. Unger, Esq. LLC can help. Todd Unger is a tax lawyer who focuses on tax controversies with the federal and state taxing authorities. The disallowance of deducing rental income losses can result in significant back taxes. Contact tax lawyer Todd S. Unger today to resolve your audit or tax litigation (877) 544-4743.