Let me tell you about Lisa and Jimmy. They had a very unsatisfactory visit with the IRS. The auditor examined their three rental properties, disallowed their losses, and told them to expect a tax bill for $55,000.
Current score: IRS $55,000 ahead.
But one good thing happened during the visit. The IRS agreed that Lisa was a real estate professional.
The bad thing was that the IRS said that Lisa did not materially participate in the rentals, because the more than 750 hours shown in her logbook included what’s called investor time.
With this, the IRS examiner said that although Lisa is a real estate professional, she failed to materially participate in the properties because she had fewer than 500 hours of material participation.
Properties
Lisa and Jimmy’s 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.
They have no personal use of the rentals.
Here’s How We Helped Lisa and Jimmy
First, let’s start with the really good news. The IRS conceded that Lisa 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.
Next, more good news: the 500 hours are not relevant. 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).
Material Participation
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 show the IRS that Lisa and Jimmy materially participated in the condo, we used the “more than 100 hours” test. This test requires that Lisa’s and Jimmy’s participation be more than 100 hours and not less than participation by any other individual.
We used the Pohoski case as our position. In this court case, 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. The IRS accepted that Lisa and Jimmy met that test.
Single-family home. Since Lisa and Jimmy did everything in connection with this rental, the IRS had no choice but to allow material participation under the “substantially all” test (one of the seven tests).
Vacation cabin. Lisa did all the work for the vacation cabin, except for that done by a housekeeper who spent three to four hours for each of the 20 weeks that the vacation cabin was rented (say 3.5 x 20 weeks, for a total of about 70 hours of housekeeping). We won material participation here because Lisa’s and Jimmy’s combined efforts were more than 100 hours and more than the housekeeper’s 70 hours.
Husband-and-Wife Time
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 combination of our work and Lisa’s and Jimmy’s good tax records enabled Lisa and Jimmy to obtain a “no change” letter—meaning that the $55,000 IRS claim was gone.
Takeaways
- 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.
If you would like my help on your rental properties, please don’t hesitate to call me on my direct line at 509-543-7600 or send a request HERE.
August 2021
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