If you claim status as a tax law–defined real estate professional who can deduct his or her rental property losses, your time record for the year must prove that you spent
- more than one-half of your personal service (personal services is defined as the time the taxpayer performs in trades or businesses during the tax year that are in real property trades or businesses) time in real property trades or businesses in which you materially participate, and
- more than 750 hours of your personal and investor services time in real property trades or businesses in which you materially participate.
If you are married, either you or your spouse must individually qualify as a real estate professional. If one spouse qualifies, both spouses qualify.
Achieving real estate professional status is the first of two steps. You face one additional hurdle. To deduct tax losses on a rental, you also must prove that you materially participated in the rental activity. If you are married, you and your spouse may count your joint efforts toward passing the material participation tests.
Most of the tests for material participation are based on hours worked.
What Do IRS Regulations Say?
The IRS says that you can establish your participation in an activity by any reasonable means. Beware of this upcoming sentence. The IRS says, “Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means.”
In this context, the IRS says that other reasonable means may include “but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”
Wow! The time log sounds easier than the “other reasonable means.”
What Do the Courts Say?
In what should be no surprise, the courts have consistently ruled against taxpayers who arrive in court without proof of time spent.
Peter Ackerman brought three witnesses to court to corroborate his claim of more than 750 hours of material participation. The court was looking for a documented record of time spent and considered the testimony lousy proof; accordingly, the court denied Mr. Ackerman’s losses.
In the Scheiner case, Ms. Scheiner testified as to time spent working, but she had no supporting written documentation. The court stated, “Given the self-serving nature of Ms. Scheiner’s testimony, coupled with the lack of corroboration in the record, we do not accept her naked assertion that she worked the requisite amount of hours…”
What Does This Mean to You?
In simple terms: keep a time log.
In an audit of your real estate activity, the IRS tells its examiner:
Request and closely examine the taxpayer’s documentation regarding time. The taxpayer is required under Reg. Section 1.469-5T(f)(4) to provide proof of services performed and [of] the hours attributable to those services.
If you don’t have what the IRS wants, your odds of winning your rental property tax loss deductions are slim, if that. And don’t think you can create this log after the fact. Most everyone who spends the considerable time it takes to jump through the hoops to create an after-the-fact log of hours using the IRS spreadsheets loses the deductions.
I can help you with this log so you spend just a little time getting this right in advance. If you want my help, please call me on my direct line at 509-543-7600.